IAS 2 - Accounting for Inventory

 

IAS 2 is an accounting standard that tells businesses how to handle inventory. Inventory refers to goods that a business:

• Buys to sell (like the stock you have in your retail store for sale),
• Is making to sell (like a manufacturer’s products that are still in the production process, also known as  work-in-progress, WIP), or
• Uses as raw materials or supplies in production process or in rendering of services (e.g., petrol used to power machines used in production, papers used in audit firms in the course of rendering professional services, etc.).

The standard gives rules for measuring inventory (deciding its cost) and recording it correctly in the financial statements.

Why is Inventory Important?

Inventory is important because it’s one of the biggest assets a business can have. If inventory is valued too high or too low, it can make the business seem more or less profitable than it really is. IAS 2 ensures businesses calculate inventory value correctly.

Measurement of Inventory

IAS 2 tells us how to measure inventory at its cost. The cost of inventory includes:

• Purchase Cost: This is what the business paid to buy the inventory. It includes:

1. The purchase price of the goods.
2. Any taxes (except VAT, if it is recoverable).
3. Shipping costs (to get the goods to the business from where they are purchased).
4. Handling costs (like loading/unloading).

• Conversion Costs: For businesses that make products, this is the cost of turning raw materials into finished products. It includes:

1. Direct labor costs (what is paid to workers making the product).
2. Manufacturing overhead (the costs to run the factory, like electricity, depreciation of machines, etc.).
3. Other Costs: Some costs might be included if necessary to bring the inventory to its present condition and location.

Exclusions from Inventory Cost

Some costs are not included in the cost of inventory. IAS 2 specifically says you should exclude:

• Abnormal waste: If goods are damaged, lost, or wasted, the cost to replace them is not included in inventory.
• Storage costs: Unless the storage is necessary during the production process, storage costs after production are excluded.
• Selling costs: Anything related to marketing, distribution, or selling is excluded.
• Administrative overheads: These are general office expenses that don’t directly relate to inventory.

Lower of Cost and Net Realizable Value (NRV)

One of the most important principles in IAS 2 is that inventory should be valued at the lower of cost and net realizable value (NRV). Let me explain this.

• Cost: This is what it cost you to get or produce the inventory (we already discussed this).
• Net Realisable Value (NRV): This is how much you think you can sell the inventory for after deducting the costs of completing it and selling it (like packaging or shipping).

So, if inventory’s NRV drops below its cost, the inventory value should be written down to its NRV. This is done so that the financial statements show a realistic value of inventory.

Example:

Let’s say you have inventory that cost ₦150,000, but because of market changes, you can only sell it for ₦120,000. To sell it, you’ll need to spend ₦10,000 on shipping. The NRV will be ₦110,000 (i.e. ₦120,000 - ₦10,000). 

Now, since NRV (₦110,000) is lower than the cost (₦150,000), you must reduce or write down the inventory’s value to ₦110,000 in your financial statements.

Methods of Assigning Costs to Inventory

When inventory consists of identical or similar items purchased at different times and prices, estimating the actual purchase cost can be difficult.

In this case, IAS 2 allows two methods to assign costs to inventory:

1. First-In, First-Out (FIFO): This method assumes the first items purchased are the first ones sold. So, the cost of inventory is based on the price of the oldest items still in stock.
2. Weighted Average Cost: This method averages the cost of all inventory items over time and applies the average to the items sold and the items remaining in stock. This is recommended.

NB: Please note that Last-In-First-Out (LIFO) is not allowed. It is however allowed in US GAAP.

Example of FIFO:

Imagine you bought 100 units of goods at ₦500 each, and later you bought 100 more units at ₦600 each. If you sell 120 units, the cost of those 120 units under FIFO will be the first 100 units at ₦500 each, and the next 20 units at ₦600 each, giving you a total cost of ₦62,000. 

The above shows that profit is calculated based on the price of the oldest inventory STILL in stock.

Example of Weighted Average Cost:

If you bought 100 units at ₦500 each and another 100 units at ₦600 each, the weighted average cost per unit would be ₦550 (i.e., [₦600 + ₦500]/2). So, if you sell 120 units, the total cost of those units would be ₦66,000 (₦550 x 120 units).

Disclosure Requirements

IAS 2 also requires businesses to disclose certain information about inventory in their financial statements:

• Total carrying amount of inventories and the amount classified into:

1. Finished goods,
2. Work in progress (goods still being made),
3. Raw materials.

• The cost formula used (FIFO or weighted average).
• The amount of any write-downs to NRV, and if any previously written-down inventory was recovered (its value went back up).
• Circumstances that led to the write-down.
• Carrying amount of inventories pledged as security for liabilities (if you used inventory to get a loan, for example).

Read Also:

• IAS 16 - Accounting for Property, Plant and Equipment