4.1 Inventory Valuation, Cost Formulas & Net Realisable Value (IAS 2)

Introduction to IAS 2

Inventory often represents one of the most significant assets on a company's Statement of Financial Position, particularly for manufacturing and retail businesses. International Accounting Standard (IAS) 2, Inventories, 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. This 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.

Under IAS 2, inventories are defined as assets:

• held for sale in the ordinary course of business;
• in the process of production for such sale; or
• in the form of materials or supplies to be consumed in the production process or in the rendering of services.

This definition encompasses merchandise purchased by a retailer and held for resale, finished goods produced, work in progress being produced by the entity, and materials and supplies awaiting use in the production process.

Measurement of Inventories

The fundamental rule for the measurement of inventories under IAS 2 is that inventories shall be measured at the lower of cost and net realisable value (NRV). This is a classic application of the concept of prudence, ensuring that assets are not overstated and that foreseeable losses are recognized immediately in the Statement of Profit or Loss.

Determining the Cost of Inventories

The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

1. Costs of Purchase The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and 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.

2. Costs of Conversion The costs of conversion of inventories include costs directly related to the units of production, such as direct labour. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and equipment, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour. The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities.

3. 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. For example, it may be appropriate to include non-production overheads or the costs of designing products for specific customers in the cost of inventories.

Costs Excluded from Inventory 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.

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. However, for items that are ordinarily interchangeable (the vast majority of retail and manufacturing inventories), an entity must assign costs by using either the First-In, First-Out (FIFO) or Weighted Average Cost (AVCO) formula. IAS 2 explicitly prohibits the use of the Last-In, First-Out (LIFO) method, as it often does not represent a reliable measure of actual inventory flows and can distort profitability during periods of inflation.

FIFO (First-In, First-Out) The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. During periods of rising prices, FIFO results in a higher valuation of closing inventory and lower cost of sales, leading to a higher reported gross profit.

AVCO (Weighted Average Cost) Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity.

Net Realisable Value (NRV)

Net Realisable Value is 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.

The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased. The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realized from their sale or use.

Inventories are usually written down to net realisable value item by item. In some circumstances, however, it may be appropriate to group similar or related items. When a write-down is necessary, the amount of the write-down is recognized as an expense in the Statement of Profit or Loss in the period the write-down occurs. If the circumstances that previously caused inventories to be written down below cost no longer exist, or when there is clear evidence of an increase in net realisable value because of changed economic circumstances, the amount of the write-down is reversed so that the new carrying amount is the lower of the cost and the revised net realisable value.