Study Unit 10

Inventories (IAS 2)

SUMMARY – STANDARD ON A PAGE

(SOAP)

IAS 2: Inventories

IAS 2 Inventories• Held for sale in ordinary course of business

• In the process of production for such sales

• To be consumed in the production of G/S for sale

Measurement

LOWER of:

Cost formulas

Weighted

average

First-in

first-out

Techniques of

measuring cost

Excludes:

• WIP under construction contracts

• Financial instruments

• Biological assets

Cost

Net realisable

value

Costs

incurred to

get into

usable form

and current

location

Estimated selling

price in ordinary

course of

business less

estimated costs

of completion

and costs of

selling

Entity must use same cost

formula for inventories with

similar nature and use

If producing in mass

you can approximate

costs

Standard

costing

Retail

method

No units x SP = x

Markup = (x)

x

Approx cost of sales

Conversion

Costs

Variable

Production

Overheads

Fixed

production

overheads

Exclude Abnormal Wastage

NATURE OF INVENTORIES

IAS 2: Inventories

Remember the asset definition

Asset Definition per the “Framework”

– A resource controlled by an entity

– as a result of past events and

– from which future economic benefits are expected

to flow to the entity

What is inventory?

• Assets that are:

– Held for sale in the ordinary course of business

– In the process of production to sell in future (partially

completed manufactured goods)

– Going to be used in the process of producing saleable

goods or services (raw materials) or are going to be

consumed in the rendering of a service (consumables)

Conceptually….

Dr Bank / Debtors (SFP) XX

Cr Revenue (P/L) xx

Record revenue from sale transaction

Dr Inventory (SFP) XX

Cr Bank / Creditors (P/L) xx

Purchase inventory

Dr Cost of Sales (P/L) XX

Cr Inventory (SFP) xx

Record cost of sales from sale transaction

MEASUREMENT - OVERVIEW

IAS 2: Inventories

How do we measure inventory?

• There are two main components that need to be quantified:

– Quantity of inventory

• Physical inventory counts

– Cost of inventory (Historical cost vs Net Realisable Value)

• Determining the cost price

• Applying a chosen cost formula (cost allocation technique)

which will be used in measuring the value of inventory

• Determining the net realisable value of the inventory

• Record inventory at the lower of cost and net realisable value

COST OF INVENTORIES

IAS 2: Inventories

How do we determine the

historical cost of inventories?

• Take into account the following:

– Cost of purchases

– Conversion costs (manufacturing)

– Other costs incurred in bringing the inventory to its

present location and current condition

Cost of inventories excludes

• Abnormal spillage / wastage of raw materials,

labour & other production costs;

• Administrative costs not directly related to

bringing inventories to the location and

condition required for sale;

• Selling expenses

CalculationPurchasing Costs Conversion Costs Other Costs

Purchase Price

Import duties

Transport costs

Handling costs

Directly attributable costs

LESS

Trade discounts

Cash/ settlement discount

Rebates on purchases

X

X

X

X

X

(X)

(X)

(X)

Direct costs incurred in

converting raw materials into

finished goods, including:

Direct labour costs

Variable production O/H costs

Fixed production O/H costs

X

X

X

Product design costs for

customers

Storage costs in the

production process

where required (eg. for

raw material storage)

Borrowing costs can be

capitalised under

certain circumstances

(IAS 23)

ALLOCATION OF OVERHEAD COSTS

IAS 2: Inventories

Overhead Costs (Indirect Costs)

1 – Production Overhead Costs

� Costs incurred in the manufacturing process

� Other than direct raw materials & direct labour

� Eg. Indirect materials, indirect labour, depreciation on production machinery –ALL part of inventory / cost of sales

2 – Other Overhead Costs

� Costs that are generally not directly related to the production function

� Eg. Human resource / personnel function; research & development; accountingand financial management; marketing etc

� Generally not included in cost of inventory, except for costs that are clearlylinked to bringing inventory to their present location and condition, including:

• Design costs and some research & development costs

• Borrowing costs (IAS 23)

• Storage costs that are necessary in the production process

Production Overheads

Variable Production Overhead Costs

� Variable as allocated cost per unit produced

� Number of units produced generally used to allocate these costs

� ie. Actual Production Capacity used to allocate cost

Fixed Production Overhead Costs

� Total cost is fixed regardless of number of units produced

� Cost per unit reduces as the number of units produced increases

� Cost allocated to individual units based on NORMAL CAPACITY for

production, not the actual production (actual capacity only used if it

approximates normal capacity.

COST ALLOCATION TECHNIQUES &

COST FORMULAS

IAS 2: Inventories

Why do we need to allocate costs

or make use of cost formula?

• Inventory is bought for different prices at different

times

– Inventory on hand at year end may include similar items

that were bought at different prices

– Which price do you use to value the cost of inventory?

Options for costing?1. Use actual costs (per unit)

• As discussed in previous lecture with actual costs and

allocated overheads

2. Cost allocation techniques (to individual units)

• Standard Costing

• Retail method

3. Cost Formula (larger group of closing inventory)

• Weighted average method

• First-in, First-out method

• Specific identification

IAS 2 notes

• The same cost formula must be used for inventories

having the same nature & use to the entity.

• Where the nature / use differs, different formulas are

allowed.

• If the same use / nature but different geographic

locations, must still use the same cost formula

COST ALLOCATION TECHNIQUES

STANDARD COSTING & RETAIL METHOD

IAS 2: Inventories

Standard Costing

• Based on expected “standard costs”, based on

normal levels of operations

• Management must set predetermined “standard”

costs for inputs into production

– Direct material

– Direct labour

– Fixed and variable overheads

• Standard costing system must approximate cost,

therefore regular review and amendment to

“standard costs” and costing inputs

Retail Method

Formula used at end of reporting period:

• Selling price value of inventories XX

• Less average profit margin (X)

• Equals approximate cost of inventory XX

� Only applied if results approximate cost, NB only if profit

margins of homogenous groups of products are known

� Suitable for businesses that do not maintain complete records

of purchases and inventories

Retail Method illustration• The inventories of a chess store based on selling price values

are equal to CU100,000 at reporting date.

• The policy for the markup on cost is 25%

� 100,000 X 100 / 125 = 80 000 Cost

• Alternatively, you could be told that a gross profit percentage

(margin on selling price) of 20% is maintained:

� 100,000 X 80/ 100 = 80 000 Cost

COST FORMULA

WEIGHTED AVERAGE METHOD

IAS 2: Inventories

Weighted Average method

• Average cost method,

• Used by entities that retain goods for a longer time,

or interchangeable items with high volumes of low-

value, fluctuating prices.

• Formula periodically or before sales:

Total cost / No. of units purchased

– This will give the cost per unit purchased

– Multiply this by units on hand at year end

Example – weighted averageDate purchased/

sold

Units purchased

/ (sold)

Unit price

CU

Value

CU

Purch 1 June 100 2.30 230.00

Purch 15 June 50 2.10 105.00

150 2.23 (WA) (CU 335 / 150 units)

335.00

Sale 26 June (75) 2.23 (WA) (167.25)

Purch 29 June 120 2.50 300.00

195 2.40 (WA) (CU 467.75 / 195 units)

467.75

Sale 30 June (155) 2.40 (WA) (372.00)

Closing inventory 40 2.40 (WA) (CU 95.75 / 40 units)

95.75

COST FORMULA

FIRST-IN, FIRST-OUT (FIFO) METHOD

IAS 2: Inventories

FIFO method

• Assumes that inventory is sold in the order in which

they were purchased.

• Older inventory items are debited to the income

statement (as cost of sales) first along with the credit

to sales.

• This means that closing inventory is calculated using

more ‘current’ prices

Example – FIFODate

purchased/

sold

Units

purchased

/ (sold)

Unit

price

CU

A

1 June

B

15 June

C

29 June

Value

CU

Purch 1 June 100 2.30 100 230.00

Purch 15 June 50 2.10 50 105.00

150 335.00

Sale 26 June (75) 2.30 (75) (172.50)

Purch 29 June 120 2.50 120 300.00

195 25 50 120 462.50

Sale 30 June

A:

B:

C:

(155)

2.30

2.10

2.50

(25)

(50)

(80)

(57.50)

(105.00)

(200.00)

Closing inv 40 Nil Nil 40 100.00

COST FORMULA

SPECIFIC IDENTIFICATION

IAS 2: Inventories

When to apply specific

identification

Specific costs are attributed to identified items of inventory in

the following to circumstances:

• The cost of inventories when the items of inventory are not

ordinarily interchangeable

• Goods / services produced & segregated for specific projects

All other costs assigned using either Weighted Average or FIFO

formulas.

LOWER OF HISTORICAL COST OR

NET REALISABLE VALUE (NRV)

IAS 2: Inventories

Net realisable value (NRV)

• NRV is calculated as the

• Estimated selling price in the ordinary course of business

Less

• Estimated costs to complete the product and to sell the

product

• Costs to sell include relevant

– Marketing costs and

– Distribution costs

• NRV is an entity-specific value

– Different to fair value less cost to sell which is NOT entity specific but

rather from view of market participant

Lower of Cost or NRV

• IAS 2 requires the inventory is measured at the

LOWER OF COST OR NRV in the Financial Statements.

• This means that you need to

– Determine both historical cost and the NRV,

– Evaluate which is lower, if cost then leave at cost, if NRV is

lower then you must write down the inventory

Indicators of Write Down

• A new assessment of net realisable value is

made in each financial year, indicators to

potential adjustments to NRV include:

– Damaged inventories

– Wholly or partially obsolete inventories

– A decline in selling prices

– Increases in estimated costs to completion

– Increases in selling costs

Net realisable value

Write-down and reversal of write-down

• Impairment to net realisable value is recognised as an

expense:

• Reversal of previous impairment is recognised in profit or loss

in period in which reversal occurs:

Dr Expense (PL) xxx

Cr Inventory (FP) xxx

Dr Inventory (FP) xxx

Cr Expense/Income (PL) xxx

Inventory obsolescence

• When inventory will not be realised, i.e., it will not be sold, it

is impaired and recognised in profit or loss:

• Management needs to apply judgement

Dr Expense (PL) xxx

Cr Inventory (FP) xxx

EXAMPLE – OBSOLETE INVENTORY

IAS 2: Inventories

Example

Allowance for obsolete inventory• Example:

– A purchases inventory for 100

– At the end of the first quarter, A estimates that inventory

of 20 is obsolete (i.e., old study material)

– At reporting date, the entity impairs inventory by 20

Dr Inventory (FP) 100

Cr Bank (FP) 100

What journal entry should be

recorded at the end of the first

quarter?

1. Dr Inventory (FP) 20

Cr Allowance for obsolescence (FP) 20

2. Dr Expense (PL) 20

Cr Allowance for obsolescence (FP) 20

3. Dr Allowance for obsolescence (FP) 20

Cr Inventory (FP) 20

4. No journal entry required

What journal entry should be recorded

at reporting date for the inventory

impairment?

1. Dr Allowance for obsolescence (FP) 20

Cr Inventory (FP) 20

2. Dr Expense (PL) 20

Cr Inventory (FP) 20

3. No journal entry required

NRV RAW MATERIAL TO BE USED IN

PRODUCTION OF FINISHED GOODS

IAS 2: Inventories

Exceptions to lower of cost or NRV

• IAS 2 par 32 notes that

– raw materials still to be incorporated into a

finished product are not written down below cost

– IF the finished product is expected to realise at

least the cost of the material and other inputs.

Example 1

NRV – Raw material & Finished Goods

• A is a manufacturer of goods

• Raw materials

– Cost = CU1 000 per unit

– NRV = CU 900 per unit

• Finished goods

– Cost = CU3 000 per unit

– NRV = CU3 200 per unit

Should raw materials be impaired?

• Answer = No

– There is no impairment to raw materials as it is

used in finished goods.

– Finished goods will be realised and need not be

impaired.

– The raw materials will never be realised other

than through the finished goods, therefore no

need to impair.

SPARE PARTS & SERVICING EQUIPMENT

IAS 2: Inventories

Spare parts & servicing equipment

• Spare parts and servicing equipment are classified as inventory

unless

- they are expected to be used during more than one period; or

- can be used only in connection with an item of Property, Plant and

Equipment (PPE)

• Product catalogues and samples used for

promotional/advertising purposes are expensed

– not classified as inventory

Spare parts & servicing equipment

• Packaging or parts that are sold to a customer, but will be

returned, are not inventory items if they will be used during

more than one period

• Packaging costs directly attributable to an inventory item are

included as part of the cost of inventory

DISCLOSURES

IAS 2: Inventories

Disclosures

• Accounting Policies – measurement & cost formula

• Carrying amounts in suitable classifications:

– Raw materials (direct materials & spare parts)

– Finished goods

– Consumable goods inventories (incl. maintenance spares)

– Work in Progress (WIP)

• The amount of inventories recognised as cost of sales during

the reporting period

• Write downs included in cost of sales (and any reversals)

• Inventory pledged as security

Statement of Profit or Loss

Revenue

Cost of Sales:

Opening Inventory

Plus: Purchases

Less: Closing Inventory

Gross Profit

XXX

(XXX)

xxx

xxx

xxx

(xxx)

XXX

Statement of Financial Position

Current Assets

Inventories

Trade and other Receivables (1)

Cash and Cash Equivalents

xxx

xxx

xxx

Accounting Policy example

Inventories are initially measured at cost and are

subsequently valued at the lower of cost or net realisable

value.

The following cost formula were applied:

• Raw materials: First-in, First-out

• Work-in-Progress: Standard Cost

• Finished Goods: Standard Cost

• Merchandise: Weighted Average

• Consumables: First-in, First-out

Excess and slow-moving inventory were identified and

written off to their estimated net realisable values