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IAS 2 – InventoriesBy Mr. Conor Foley, B. Comm., MAcc., FCA, Dip IFRExaminer: Formation 2 Financial AccountingThis article provides information and application in relation to IAS 2 – Inventories.Inventories – What are they?Inventories, per paragraph 6 of IAS 2 are assets that area) Held for sale in the ordinary course of businessb) In the process of production for such sale; orc) In the form of materials or supplies to be consumed in the production processor in the rendering of services.Inventories per IAS 2 comprisea) Merchandiseb) Production Suppliesc) Materialsd) Work in Progresse) Finished GoodsIn the case of a service provider, inventories include the costs of the service forwhich the entity has not yet recognised the related revenue. These costs consistprimarily of the labour and other costs of personnel directly engaged in providing theservice, including supervisory personnel and attributable overheads. Labour andothers costs relating to sales and general administrative personnel are not includedbut are recognised as expenses in the period in which they are incurred.Valuation of InventoriesInventories are measured at the lower ofa) CostOrb) Net Realisable Value (NRV)Page 1 of 9

Each item of inventory is valued separately.Example 1Suppose a company has three items of inventories on hand at the year-end. Theircosts and NRVs are as follows:Item123Cost - NRV - Lower of Cost/NRV - 364028244648110112Calculate the closing value of inventory at the year-end?Solution Example 1It would be incorrect to compare the total cost of 110 with total NRV of 112 andstate inventories as 110. The comparison should be made for each item ofinventory and thus a value of 106 would be attributed to inventories i.e.Item123Cost - 362846110NRV - 402448112Lower of Cost/NRV - 362446106Allowable Costs per IAS 2Per paragraph 10 of IAS 2, the cost of inventories shall comprise all costs ofpurchase, costs of conversion and other costs incurred in bringing the inventories totheir present location and condition.a) Costs of purchase comprise purchase price, import duties and other taxesand transport, handling and other costs directly attributable to the acquisitionof finished goods, materials and services, less trade discounts, rebates andother similar itemsb) Costs of conversion includei)Costs which are directly related to units of production i.e. direct labour,direct expenses and sub-contracted workii)Systematic allocation of fixed and variable production overheadsincurred in converting materials into finished goodsc) Other costs can be included in the cost of inventories to the extent incurred inbringing the inventories to their present location and condition i.e. nonproduction overheads of designing a product for a specific customer.Page 2 of 9

Paragraph 16 of IAS 2 outlines examples of costs which are excluded from the costof inventories and instead recognised as expenses in the period in which they areincurred i.e.a) Abnormal amounts of wasted materials, labour or other production costs;b) Storage costs unless these costs are necessary in the production processbefore a further production stage;c) Administrative overheads that do not contribute to bringing inventories to theirpresent location and condition; andd) Selling costs.Techniques for the Measurement of CostEstimation techniques may be used for convenience if the results approximate toactual costs. Examples of potential estimation methods include:a) Standard Cost: Cost is based on normal levels of materials and supplies,labour efficiency and capacity utilisation. They are regularly reviewed andrevised where necessaryb) Retail Method: Cost is determined by reducing the sales value of the inventoryby the appropriate percentage gross margin. The percentage used takes intoconsideration inventory that has been marked down to below its originalselling price. This method is often used in the retail industry for measuringinventories of rapidly changing items that have similar margins.Example 2Bacon Timothy (BT) is a new luxury retail company located in Grafton Street inDublin. Its accountant previously worked abroad and is not familiar with internationalfinancial reporting standards and has asked you, the trainee accountant, to giveadvice on the accounting treatment necessary for the following items;a) One of BT’s product lines is beauty products, particularly cosmetics such aslipsticks, moisturisers and compact make-up kits. BT sells hundreds ofdifferent brands of these products. Each product is quite similar, is purchasedat similar prices and has a short lifecycle before a new similar product isintroduced. The point of sale and inventory system in BT is not yet fullyfunctioning in this department.The sales manager of the cosmeticdepartment is unsure of the cost of each product but is confident of the sellingprice and has reliably informed you that BT, on average, make a gross marginof 65% on each line.b) BT also sells handbags. BT manufactures their own handbags as they wishto be assured of the quality and craftsmanship which goes into each handbag.The handbags are manufactured in the UK in the head office factory whichPage 3 of 9

has made handbags for the last fifty years. Normally, BT manufactures100,000 handbags a year in their handbag division which uses 15% of thespace and overheads of the head office factory. The division employs tenpeople and is seen as being an efficient division within the overall company.In accordance with IAS 2 - Inventories, explain how the items referred to in a)and b) should be measuredSolution Example 2The retail method can be used for measuring inventories of the beauty products.The cost of the inventory is determined by taking the selling price of the cosmeticsand reducing it by the gross margin of 65% to arrive at the cost.The handbags can be measured using standard cost especially if the resultsapproximate cost. Given that BT has the information reliably on hand in relation todirect materials, direct labour, direct expenses and overheads, it would be the bestmethod to use to arrive at the cost of inventories.Cost FormulasPer paragraph 23 of IAS 2, the cost of inventories of items that are not ordinarilyinterchangeable and goods or services produced and segregated for specificprojects shall be assigned by using specific identification of their individual costs.If various batches of inventories have been purchased at different times during theyear and at different prices, it may be impossible to determine precisely which itemsare still held at the year-end and therefore, what the actual purchase cost of thegoods was.In such circumstances, the following estimate methods are allowed under IAS 2;a) FIFO (First In First Out)The calculation of the cost of inventories is on the basis that the quantities inhand represent the latest purchases or production and those items ofinventory that were purchased or produced first are sold first.ORb) Weighted Average CostThe calculation of the cost of inventories is determined by using a weightedaverage price computed by dividing the total cost of items by the total numberof such items. The price is recalculated on a periodic basis or as eachadditional shipment is received and items taken out of inventory are removedat the prevailing weighted average costThe use of LIFO (Last In First Out) is not permitted.Page 4 of 9

Example 3On 1st June 2015 a company held 400 units of finished goods valued at 22 each.During June, the following transactions took placeDate10/06/1520/06/1525/06/15Units Purchased300400500Cost per Unit 23 24 25Goods sold out of inventories during December were as follows:Date14/06/1521/06/1528/06/15Required:Units Sold600400100Sales Price per Unit 30.00 31.00 32.00Calculate the value of closing inventories usinga) FIFOb) Weighted Average CostSolution Example 3Page 5 of 9

Net Realisable ValueThis is the estimated selling price in the ordinary course of business less:a) Estimated costs of completionb) Estimated costs necessary to make the sale i.e. marketing, selling anddistribution costsEstimates of NRV are based on the most reliable evidence available at the time theestimates are made of the amount the inventories are expected to realise. Theseestimates take into consideration fluctuations of price or cost directly relating toevents occurring after the end of the period to the extent that such events confirmconditions existing at the end of the period.A new assessment is made of net realisable value in each subsequent period. Whenthe circumstances that previously caused inventories to be written down below costno longer exist or when there is clear evidence of an increase in net realisable valuebecause of changed economic circumstances, the amount of the write down isreversed (i.e. the reversal is limited to the amount of the original write down) so thatthe new carrying amount is the lower of the cost and the revised net realisable valuePage 6 of 9

NRV CostThe principal situations in which net realisable value is likely to be less than cost iswhere there has been;a)b)c)d)An increase in costs or a fall in selling pricePhysical deterioration of inventoriesObsolescence of ProductsA decision as part of a company’s marketing strategy to manufacture and sellproducts at a losse) Errors in production or purchasingExample 4Inventory at 31 December is 146,000. This includes obsolete inventory costing 4,240 which will be given away free to a local children’s charity.Solution Example 4Example 5Ramona limited’s year-end inventory amounted to 142,800 valued at cost. Includedin this amount is some timber garden furniture which has been damaged by a forkliftand is beyond repair. The cost of this damaged inventory was 4,650. Ramonalimited sold it to a local wood chip company for 1,200 and incurred transport costsof 170.Page 7 of 9

Solution Example 5Example 6Inventory at 31 December 2014 is 243,510. This includes 2,410 for itemsaccidentally destroyed on 3 January 2015 and 1,540 which relates to the cost ofdamaged inventory which can be reworked at a cost of 200 and which can then besold for 1,230.Solution Example 6Example 7Tingling Limited’s year-end inventory at the 31 December amounted to 164,300valued at cost. However, some inventory items were damaged prior to year-end andwill require repair work that will cost an estimated 1,280. When repaired, the itemscan be sold for 90% of cost. The cost of these damaged goods was 2,400.Page 8 of 9

Solution Example 7DisclosurePer paragraph 36, an entity shall disclosea) The accounting policies adopted in measuring inventories, including the costformula used;b) The total carrying amount of inventories and the carrying amount inclassifications appropriate to the entity;c) The carrying amount of inventories carried at fair value less costs to selld) The amount of inventories recognised as an expense during the period;e) The amount of any write down of inventories recognised as an expense in theperiod in accordance with paragraph 34;f) The amount of any reversal of any write down that is recognised as areduction in the amount of inventories recognised as expense in the period inaccordance with paragraph 34;g) The circumstances or events that led to the reversal of a write down ofinventories in accordance with paragraph 34; andh) The carrying amount of inventories pledged as security for liabilities.Paragraph 34 states that when inventories are sold, the carrying amount of thoseinventories shall be recognised as an expense in the period in which the relatedrevenue is recognised. The amount of any write down of inventories to net realisablevalue and all losses of inventories shall be recognised as an expense in the periodthe write down or loss occurs. The amount of any reversal of any write down ofinventories, arising from an increase in net realisable value, shall be recognised as areduction in the amount of inventories recognised as an expense in the period inwhich the reversal occurs.Page 9 of 9