IAS 2 – INVENTORIES
The objective of this IAS is to prescribe the accounting treatment of inventories.
Inventories are assets; –
- Held for sale in the ordinary course of business
- In the process of production for such sale; or (work in progress, finished goods awaiting to be sold)
- In the form of materials or supplies to be consumed in the production process or in the rendering of services
Net Realizable Value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated cost necessary to make a sale.
MEASUREMENT OF INVENTORIES
Inventory shall be measured at the lower of cost and net realizable value.
COST OF INVENTORIES
The cost of inventories will comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.
- Purchase cost comprise the;
- i) Purchase price plus; ii) Import duties and other non –refundable taxes;
- Transport, handling and any other cost directly attributable to the acquisition of finished goods, services and materials; less
- Trade discounts, rebates and other similar amounts
- Cost of conversion
- Costs directly related to the units of production (direct labor); and
- Systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. (Factory rent, depreciation of machinery, supervisor salary, power consumption)
The allocation of fixed overheads to the costs of conversion is based on the normal capacity of the production facilities.
- Other cost incurred in bringing the inventories to their present location and condition (i.e. non production overheads or costs of designing products for specific customers).
The Standard excludes the following from the cost of inventories
- The abnormal amount of wasted material, labor or other production cost;
- Storage costs unless necessary for production before the further production process/stage;
- Administrative overheads that do not contribute to bringing inventories to their present location and condition;
- Selling cost
- Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign currency
- Interest cost when inventories are purchased with deferred settlement terms
Costs of Inventories of a service provider
The cost of inventories of service providers includes primarily the labour and other cost of the personnel directly engaged in providing the service including supervisory personnel and directly attributable overheads.
For items that are interchangeable, IAS 2 allows the FIFO or weighted average cost formulas.
The LIFO formula, which had been allowed prior to the 2003 revision of IAS 2, is no longer allowed.
NET REALIZABLE VALUE
As a general rule assets should not be carried at amounts greater than those expected to be realized from their sale or use. In case of inventories this amount could fall below cost when items are damaged or become wholly or partially obsolete, or where the costs to completion have increased in order to make the sale or the prices have declined. (Prudence Concept).
The principal situations in which NRV is likely to be less than cost, i.e. where there has been:
- An increase in costs or a fall in selling price
- A physical deterioration in conditions of inventory
- Obsolescence of products
- A decision as part of the company‘s marketing strategy to manufacture and sell products at a loss Errors in production or purchasing RULES:
- The write down of inventories would normally take place on an item-by-item basis but similar or related items may be grouped together (in case of service provider each service will be treated as item).
- The NRV should be based on the most reliable evidence available at the time of estimates are made.
- Fluctuations after reporting date should also be taken into account to the extent they confirm the conditions existing at the reporting date.
- The estimate of NRV should also take into account the purpose for which the inventory is held (firm sale / purchase contracts).
- Materials or supplies held for use in the production process should not be written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. Otherwise, when the decline in the value of materials indicates that the cost of finished goods exceeds NRV, the materials should be written down to NRV.
- NRV should be reassessed at each reporting date and necessary adjustments such as further reduction or increase in NRV should be made however, reversal of write down is limited to the original write down of inventories.
- Material reductions should be disclosed separately
RECOGNITION AS EXPENSE
The following treatment is required, when inventories are sold.
- The carrying amount is recognized as an expense in the period in which the related revenue is recognized (matching concept)
- The amount of any write down of inventories to NRV and all losses of inventories are recognized as an expense in the period in which the related write down or loss occurred
- The amount of any reversal of any write down of inventories, arising from the increase in NRV is recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.
The inventories allocated to other assets i.e. when the inventory becomes the part of cost of selfconstructed assets, the inventories are recognized as an expense over the useful life.