International Accounting Standard 2- Inventories

 International Accounting Standard 2- Inventories

The International Financial Reporting Standard IAS 2- INVENTORY prescribes the accounting treatment for inventory.

This Standard provides guidance on:

• ·         the determination of cost and its subsequent recognition as an expense,

• ·        Any write-down to net realisable value, as well as reversal of this write-down

• ·          It also provides guidance on the cost formulas that are used to assign costs to inventories.

Inventories are assets:

(           (a)    held for sale in the ordinary course of business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

This therefore means, Inventories are assets held by and entity, whether by virtue of purchase or production, or in the process of production in which the entity intends to sell in its normal course of business. Thus, Motor van acquired by a Manufacturing company, with the intention of using it to distribute goods is not an inventory, whereas  a motor van purchased by a Motor dealer whose purpose is to resell the van in its ordinary course of business will be classified as inventory.

Succinctly, Inventory includes:

·         Finished Goods

·         Work-in-progress

·         Raw materials and

·         Consumable supplies

In the case of a service provider, inventories include the costs of the service, for which the entity has not yet recognised the related revenue.

MEASUREMENT OF INVENTORY

Inventories shall be measured at the lower of cost and net realisable value.

COST OF INVENTORY

The cost of inventories shall comprise all:

 costs of purchase,                                                           X

costs of conversion and                                                     X

other costs                                                                      X

                                                                                       X

 

The above costs must be those incurred in bringing the inventories to their present location and condition.

NET REALISABLE VALUE

This 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.

Estimated Selling price                                         X

Estimated Cost to complete (if applicable)             (x)

Estimated cost to sell                                           (x)

                                                                           X

Note, Net realisable value is not the same as Fair value. NRV is an entity-specific value, while Fair value is a market-based valuation. Net realisable value for inventories may not equal fair value less costs to sell.

JUSTIFICATION FOR THE MEASUREMENT

·         When Cost is higher than NRV: 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 realised from their sale or use.

·         When NRV is higher than Cost: The practice of not writing inventory above cost is probably to observe the prudence principle.

The cost of inventories may not be recoverable if:

1.       those inventories are damaged;

2.       if they have become wholly or partially obsolete;

3.       if their selling prices have declined;

4.       if the estimated costs of completion have increased; or

5.       the estimated costs to be incurred to make the sale have increased.

Techniques for the measurement of cost 

The cost of inventory can be approximately arrived at using the following techniques:

a.       Standard cost method: Standard costs take into account normal levels of materials and supplies, labour, efficiency and capacity utilisation.

b.      Retail method: The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate percentage gross margin.

COST FORMULA

These are formulas that are used to assign cost to inventory.  It facilitates the assignment of cost in determining Cost of sales of inventory, Cost of closing inventory, etc.

A.      When the Inventories are not Ordinarily Interchangeable: 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.

·         Not Ordinarily Interchangeable: This is not remote, it means the items of inventory are heterogeneous; they are not looking similar or perfectly similar.

·         Specific Identification: Specific identification of cost means that specific costs are attributed to identified items of inventory.

B.      When the Inventories are not Ordinarily Interchangeable: The cost of inventories, other than those dealt with in A above, shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula.

·         Ordinarily Interchangeable: This means the items of inventory are homogeneous, one can easily or perfectly replace the other.

N:B Last-in, last-out cost (LIFO) formula is not permitted by IAS 2.

RECOGNITION AS AN EXPENSE

·         When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised.

·         The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs.

·         The amount of any reversal of any write-down of inventories, arising from an increase in net realisable value, shall be recognised as a reduction in the amount of inventories  recognised as an expense in the period in which the reversal occurs.