Inventories

(LKAS 02)
Lecture Outline
• Objectives of LKAS 02
• Scope of LKAS 02
• Definitions
• Measurement of inventories
– Cost of inventories
– Cost formulas
– Net Realizable Value
• Recognition as an Expense
• Disclosures
Objectives of LKAS 02
↣ It prescribes the accounting treatment for inventories.
↣ A primary issue in accounting for inventories is the
amount of cost to be recognized as an asset and carried
forward until the related revenues are recognized

↣ 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.
Scope of LKAS 02
LKAS 2 excludes certain inventories from its scope:
↣ Work in process arising under construction
contracts
(LKAS 11 Construction Contracts)
↣  Financial Instruments
(LKAS 32 & 39 Financial Instruments: Recognition
and Measurement)
↣  Biological assets related to agricultural activity
and agricultural produce at the point of harvest
(LKAS 41 Agriculture)
Scope of LKAS 02
Also, while the following are within the scope of the
standard, LKAS 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.
Scope of LKAS 02
Also, while the following are within the scope of the
standard, LKAS 2 does not apply to the measurement of
inventories held by:
↣ 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.
Definitions
The following terms are used in this standard with the
meanings specified:
↣ Inventories
↣ Net Realizable Value
↣ Fair Value
Inventories
↣ Assets are held for sale in the ordinary course of
business; - Finished Goods
↣ Assets are in the process of production for such
sale; or – Work-In-Progress
↣ Assets are in the form of materials or supplies to be
consumed in the production process or in the
rendering of services. – Raw Materials
Net Realizable Value
The estimated selling price in the ordinary course of
business less the estimated costs of completion and the
estimated costs necessary to make the sale.

Estimated costs of completion

Estimated
NRV = Selling Price - and the costs necessary to
make the sale.

Net realisable value refers to the net amount that an

entity expects to realize from the sale of inventory in the
ordinary course of business
Fair Value
↣ The amount for which an asset could be exchanged,
or a liability settled, between knowledgeable, willing
parties in an arm’s length transaction.

↣ the price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction
between market participants at the measurement
date.

↣ NRV ≠ FV
Measurement of Inventories
Inventories shall be measured at the lower of cost and net
realizable value.
↣ Cost of Inventories
↣ Costs of Purchase
↣ Costs of conversion
↣ Other costs
↣ Costs of inventories of a service provider
↣ Costs of agricultural produced harvested from biological assets
↣ Techniques for the measurement of cost

↣ Cost formulas
↣ Net Realizable Value
Cost of Inventories
The cost of inventories shall comprise all costs of
purchase, costs of conversion and other costs incurred
in bringing the inventories to their present location and
condition.

Cost Cos Cos

Other
costs
incurred
of t of t of in
bringing

Inve Pur Con the

inventori
es to their
ntor cha vers present
location
ies se ion and
condition.
Cost of Purchase
The costs of purchase of inventories comprise:
↣ purchase price,
↣ import duties and other taxes (other than those
subsequently recoverable by the entity from the
taxing authorities),
↣ transport,
↣ handling and other costs directly attributable to the
acquisition of finished goods, materials and services.
Trade discounts, rebates and other similar items are
deducted in determining the costs of purchase.
Example – 1
Kanchana Ltd. incurred the following expenses in relation
to the inventories.
↣ Raw materials purchased (40,000 units @ Rs. 8.00)
↣ Import duties and other non refundable taxes Rs.
32,000
↣ Clearing expenses Rs. 16,000
↣ Unloading charges Rs.12,000
↣ Transport costs Rs. 10,000
↣ 10% trade discount allowed by the supplier.
↣ Rebate of Rs. 2.00 per unit granted by the
government.
Compute the cost of the purchases.
Solution for Example – 1
Description Amount (Rs.)
Purchase Price 40,000 x Rs. 8 320,000
Taxes 32,000
Clearing Expenses 16,000
Unloading Charges 12,000
Transport 10,000
390,000
(-) Trade Discount 320,000 x 10% (32,000)
(-) Rebate 40,000 x Rs. 2 (80,000)
Cost of Purchase 278,000
Example – 2 – Practice yourself
Y Ltd. purchased 10,000 units of product A at Rs. 37.00
each.
Following expenses were incurred.
↣ Import duties and other non refundable taxes Rs. 55,000
↣ Clearing Charges Rs. 5,000
↣ Unloading charges Rs. 7,500
↣ Carriage inwards Rs. 4,750
↣ The supplier offered a 5% trade discount on the
purchases
↣ When the imported number of units is more than 7,500
units, the Government offered a rebate of Rs. 4.50 for
each excess unit
Compute the cost of the purchases.
Cost of Conversion

The costs of conversion of inventories include:

↣ costs directly related to the units of production, such

as direct labour.

↣ systematic allocation of fixed and variable

production overheads that are incurred in
converting materials into finished goods.
Cost of Conversion

Fixed production overheads are those indirect costs of

production that remain relatively constant regardless of
the volume of production.

Examples:

↣ Depreciation and maintenance of factory buildings

and equipment

↣ cost of factory management and administration.

Cost of Conversion

Variable production overheads are those indirect costs

of production that vary directly, or nearly directly, with
the volume of production.

Examples:

↣ indirect materials

↣ indirect labour
Example - 3
Alpha Ltd. incurred the following expenses when importing raw materials and
manufacturing goods.
Raw materials 50,000 units @ Rs. 5.00 each.
Import duties and non refundable taxes Rs. 110,000
Clearing expenses Rs. 35,000
Unloading costs Rs. 15,000
Transport expenses Rs. 20,000
Trade discount from supplier 2%
10 cents government rebate per unit
One unit of completed product requires 5 units of raw materials
Direct labor cost per unit is Rs.30.00
Fixed overheads during the year is Rs. 240,000
Variable overheads during the year is Rs. 180,000 and normal capacity is
10,000 units.
During the period, introduced and completed production is 8,000 units & Sales
- 3000 units
Calculate the cost of the inventories.
Example – 4 – Practice yourself
X Ltd incurred following expenses for purchases and
production.
Raw materials consumed Rs. 450,000
Direct labor cost Rs. 200,000
Other direct expenses Rs. 40,000
Variable Production Over heads Rs. 120,000
Administrative overheads Rs. 50,000
Fixed production overheads Rs. 300,000
Number of units produced 70,000
Average capacity for the year is 80,000 units
Calculate the cost per unit
Other Costs

Other costs are included in the cost of inventories only to

the extent that they are incurred in bringing the
inventories to their present location and condition.

Example:

It may be appropriate to include non-production

overheads or the costs of designing products for
specific customers in the cost of inventories.
Other Costs
Examples of costs excluded from the cost of inventories
and recognized as expenses in the period in which they
are incurred are:
↣ abnormal amounts of wasted materials, labour or other
production costs;
↣ storage costs, unless those costs are necessary in the
production process before a further production stage;
↣ administrative overheads that do not contribute to
bringing inventories to their present location and
condition; and
↣ selling costs.
Other Costs
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.
Cost of inventories of a service provider

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.
Cost of inventories of a service provider

Labour and other costs relating to sales and general

administrative personnel are not included but are
recognized 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.
Cost of Agricultural Produce Harvested
from Biological Assets
Inventories comprising agricultural produce that an
entity has harvested from its biological assets are
measured on initial recognition at their fair value less
estimated point-of-sale costs at the point of harvest.
This is the cost of the inventories at that date for
application of this Standard.
Techniques for the Measurement of Cost
Techniques for the measurement of the cost of
inventories, such as the standard cost method or the
retail method, may be used for convenience if the
results approximate cost.

Standard Cost Method

Standard costs take into account normal levels of
materials and supplies, labour, efficiency and capacity
utilization.
They are regularly reviewed and, if necessary, revised in
the light of current conditions.
Techniques for the Measurement of Cost
Retail Method
The retail method is often used in the retail industry for
measuring inventories of large numbers of rapidly
changing items with similar margins for which it is
impracticable to use other costing methods.
The cost of the inventory is determined by reducing the
sales value of the inventory by the appropriate
percentage gross margin.
The percentage used takes into consideration inventory
that has been marked down to below its original selling
price. An average percentage for each retail department
is often used.
Example - 5
A Ltd. Use retail method to calculate its cost of
inventories. Average gross margin is 20%.
Opening Stocks Rs. 360,000
Purchase Rs. 1,440,000
Sales Rs. 1,500,000
Example - 5
Opening Stocks Rs. 360,000
Purchase Rs. 1,440,000
Rs. 1,800,000
Sales (Rs. 1,500,000)
Cost of inventories Rs. 300,000

Gross Margin Rs. 300,000 x 20 =Rs.

50,000
120

So, Cost of Inventories = Rs. 300,000 – Rs. 50,000

= Rs. 250,000
Cost Formulas
The cost of inventories of items that are not ordinarily
interchangeable and goods or services produced and
segregated for specific projects shall be assigned by using
specific identification of their individual costs.

Specific identification of cost means that specific costs are

attributed to identified items of inventory. This is the
appropriate treatment for items that are segregated for a
specific project, regardless of whether they have been bought
or produced.
Example - 6
• A company made the following purchases and sales during the
month of April 2017:
Date Units Purchased Units sold Balance (Units)
Apr. 01 1,000 units @ Rs. 2.00 1000
Apr. 12 3,000 units @ Rs. 2.20 4000
Apr. 17 2000 2000
Apr. 30 1,000 units @ Rs. 2.40 3000

• The 3,000 units in the inventory on April 30 is composed of

– 500 units from purchases made on April 01,
– 1,500 units from purchases made on April 12 and
– 1,000 units from purchases made on April 30.
Calculate the cost of ending inventory and the cost of goods
sold using specific identification method of inventory valuation.
Solution for Example - 6

Date Balance Units @ unit Total Value

value
Apr. 01 500 units Rs. 2.00 Rs. 1,000
Apr. 12 1,500 units Rs. 2.20 Rs. 3,300
Apr. 30 1,000 units Rs. 2.40 Rs. 2,400
Total value of ending balance Rs. 6,700
Cost Formulas
The cost of inventories, shall be assigned by using the,
↣ First-In-First-Out (FIFO)

↣ Weighted Average Cost

An entity shall use the same cost formula for all

inventories having a similar nature and use to the entity.
For inventories with a different nature or use, different
cost formulas may be justified.
Example - 7
A Ltd.’s data relating to inventories are provided below.
Inventories as at 1st January 2017 is 1,000 units.
Cost per unit Rs. 5.00
Inventory receipts
2017.01.09 - 4000 units @ Rs. 6.00each
2017.01.13 - 1500 units @ Rs. 8.00 each
2017.01 21 - 3000 units @ Rs. 9.00 each
2017.01.28 - 6000 units @ Rs. 10.00 each
Inventories Issues
2017.01.11 - 3000 units
2017.01.16 - 2000 units
2017.01.25 - 2500 units
Calculate the value of the inventory as at 31st January, 2017 by using
FIFO and Weighted Average Method.
Net Realizable Value
The cost of inventories may not be recoverable if those
inventories:
↣ damaged,
↣ become wholly or partially obsolete,
↣ selling prices have declined.
↣ estimated costs of completion or the estimated costs
to be incurred to make the sale have increased.
Net Realizable Value
IF SO WHAT TO DO????????????

The practice is to write inventories down below cost to

net realisable value.

It is consistent with the view that assets should not be

carried in excess of amounts expected to be realised
from their sale or use.

Inventories are usually written down to net realizable

value item by item.
Net Realizable Value
Estimates of net realizable value are based on the most
reliable evidence available at the time the estimates are
made, of the amount the inventories are expected to
realize.

Methods of determination of NRV

Item by Item method
Grouping method
Example - 8
The following inventory details were extracted from A Ltd.’s books

Write down to NRV on Item by item basis & grouping basis.

Recognition as an Expense
↣ When inventories are sold, the carrying amount of
those inventories shall be recognized as an expense in
the period in which the related revenue is recognized.

↣ The amount of any write-down of inventories to net

realizable value and all losses of inventories shall be
recognized as an expense in the period the write-
down or loss occurs.
Recognition as an Expense
↣ The amount of any reversal of any write-down of
inventories, arising from an increase in net
realizable value, shall be recognized as a reduction
in the amount of inventories recognized as an
expense in the period in which the reversal occurs.

↣ Inventories allocated to another asset are

recognized as an expense during the useful life of
that asset. Ex: inventory used as a component of
self-constructed PPE.
Disclosures
↣ The financial statements should disclose:

↣ the accounting policies adopted in measuring

inventories, including the cost formula used;
↣ the total carrying amount of inventories and the
carrying amount in classifications appropriate to
the entity;
↣ the carrying amount of inventories carried at fair
value less costs to sell;
↣ the amount of inventories recognized as an
expense during the period;
Disclosures
↣ The financial statements should disclose:

↣ the amount of any write-down of inventories

recognized as an expense in the period
↣ the amount of any reversal of any write-down
that is recognized as a reduction in the amount of
inventories recognized as expense in the period
↣ 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.
Did We?????
• Objectives of LKAS 02
• Scope of LKAS 02
• Definitions
• Measurement of inventories
– Cost of inventories
– Cost formulas
– Net Realizable Value
• Recognition as an Expense
• Disclosures
Next week…………

Property, Plant & Equipment

(LKAS 16)