Inventories are one of the critical assets in any business. What is inventory? IAS 2 Inventories provides a specific definition of inventories which is defined as assets that are:
- 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.
So long an asset meets the definition above, such an asset should be classified as inventory. IAS 2 however, does not apply to (1) financial instruments; and (2) biological assets related to agricultural activity and agricultural produce at the point of harvest.
Here, we have prepared for you 10 quick facts relating to inventories based on the requirements of IAS 2.
#1: What is the measurement principle for inventories?
IAS 2 requires inventories to be measured at the lower of cost and net realisable value. This means inventories cannot be carried more than their net realisable value. Entities are required to perform this assessment at each reporting period.
#2: What is net realisable value and why inventories cannot be carried more than the net realisable value?
From the technical perspective, net realisable value is defined as the estimated selling price of the inventories in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
In layman’s term, net realisable value (or also known as NRV) is the amount expected to be realised from the sale or use of the inventories, and this amount takes into consideration the expected cost to complete the “work-in-progress” inventories and the expected costs to sell them.
#3: How do we determine the estimated costs necessary to make the sale?
We have covered the discussion on the estimated costs necessary to make the sale in IFRIC Tentative Agenda Decision: Costs Necessary to Sell Inventories. Currently, the tentative agenda decision is still open for public comments until 14 April 2021. The tentative agenda decision is available on IASB’s website – Tentative Agenda Decision and comment letters: Costs Necessary to Sell Inventories (IAS 2).
#4: In what situations the cost of inventories are higher than the net realisable value?
IAS 2 provides some explanation and examples of situations where the cost of inventories are higher than the NRV. For instance, the inventories are damaged or obsolete and cannot fetch the current market selling price. In another situation, the cost of inventories can also be higher than the NRV when the estimated costs to make the sale and cost to complete the inventories have increased.
#5: What happens when the cost of inventories is higher than the net realisable value?
Whenever the cost of inventories is higher than the NRV, IAS 2 requires entities to write down the cost to the NRV, so that no inventories are carried in the book more than the expected amount to be realised from its use or sale. This essentially reflects the potential economic benefits that entities are expected to derive from the use or sale of the asset (inventories).
In another situation, it may also be possible for the NRV to be higher than the cost of inventories in the subsequent period. When there is clear evidence of an increase in NRV because of changes in economic circumstances, the amount of inventories written down previously shall be reversed.
#6: How do we measure the cost of inventories?
In measuring the cost of inventories, entities should take into consideration the costs of purchasing the inventories, the cost of converting the inventories (cost of conversion) and other costs that entities need to incur in bringing the inventories to their present location and condition.
| Costs of purchase | Costs of conversion | Other costs |
|---|---|---|
| Includes: – Purchase price – Import duties – Other taxes – Other costs that are directly attributable to the acquisition of finished goods, materials and services – Trade discounts, rebates and other similar items. | Costs directly related to the unit of production such as: – Direct labour – Allocation of fixed and variable production overheads | Other types of costs so long they are incurred in bringing the inventories to their present location and condition. IAS 2 specifically excludes the following costs from the cost of inventories: – Abnormal amount of wasted materials, labour and other production costs. – Storage costs, unless the costs are necessary in the production process before a further production stage. – Administrative overheads that do not contribute to bringing the inventories to the present location and condition. – Selling costs. |
Exception for the measurement of costs above is on the cost of agricultural produce harvested from biological assets. Where agricultural produce harvested from biological assets are classified as inventories, they are measured at the fair value of the produce at the point of harvest.
#7: Can an entity capitalise borrowing cost as the cost of inventories?
IAS 2 does not prohibit entities from capitalising borrowing cost as part of the cost of inventories. Entities, however, must follow the guidance in IAS 23 Borrowing Costs to determine whether the borrowing costs incurred are eligible for capitalisation.
#8: How do we determine the cost of inventories for interchangeable items?
Challenge arises when items are produced interchangeably – i.e. a large number of items are produced out of the production process and the costs of converting each product are not separately identifiable. In this situation, IAS 2 states that the cost of inventories for such items should be assigned by using either the first-in, first-out method (“FIFO”) or weighted average cost formula. The selection of cost formula must be applied consistently for all inventories with similar nature and use to the entity. However, it is also possible to change from one cost formula to another in certain circumstances but entities must observe the requirements under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
For items that are not interchangeable and the costs can be specifically identified, IAS 2 emphasise that the costs of such items must be based on specific identification of their individual costs.
#9: When do we recognise the cost of inventories as an expense?
The cost of inventories is generally capitalised in the financial statements unless those costs are not eligible for capitalisation. The cost of inventories will only be expensed off in profit or loss when inventories are sold and the related revenue is recognised.
#10: What are the disclosure requirements for inventories?
Similar to other IFRS standards, IAS 2 also provides a list of information to be disclosed in the financial statements relating to inventories. Besides the normal disclosure requirements relating to the accounting policies for inventories and the carrying amount of inventories, IAS 2 also requires the following disclosures:
- The amount of inventories recognised as an expense during the period;
- The amount of inventories written down or reversal of any write-down;
- The circumstances and events that led to the reversal of a write-down of inventories; and
- The carrying amount of inventories pledged as security for liabilities.
The 10 quick facts above summarise the principles included in IAS 2. Stay tuned for our upcoming factsheet series for other standards. In the meantime, you can read other articles published in the Financial Accounting section.