The International Accounting Standards Board (IASB) created International Accounting Standards 2 (IAS 2) for the valuation of inventories. IAS 2 prescribes the accounting methods for inventories. According to the requirement, the inventories must be measured at lower of the cost and net realizable value. The guidelines for determining the cost are also provided by International Accounting Standard 2. This leads to recognition of expenses, including any write-down to net realizable value.
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The Following Items Can Be Considered As Inventory: [IAS 2.6]
- The assets for sale in the normal course of business. These are finished goods.
- The assets used in the production process for sale.
- It is the material and supplies used in production. These are the raw materials.
The Following Inventories Fall Outside The Scope of IAS 2
- Any ‘work in process’ asset under construction contracts.
- Different financial instruments
- Biological assets which are associated with agricultural activity.
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IAS 2 Is Not Applicable For The Inventories That Are Held By
- Producers of forest and agricultural products, minerals and mineral products and produce after harvest. When the inventories are measured at net realisable value, the changes in the values will be considered as profit or loss.
- Commodity brokers and dealers. They measure the inventory at fair value less costs to sell. In this case, changes in the fair value less cost to sell are considered as profit or loss for the period of change.
Measurement of IAS 2 Inventories
In IAS 2.10, it is stated that the cost includes costs of purchase, costs of conversion and other costs that were incurred for transporting the inventories to the current location.
Purchase costs may include non-refundable duties and taxes plus if there is any cost of acquisition. Discount is deducted when calculating the cost of acquisition.
Cost of conversion may include the cost of labour and other overheads that are incurred to convert the raw material to finished goods.
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There Are Two Categories of Conversion Costs
1. Direct Cost
The costs that are directly associated with the product such as labour.
2. Fixed Overhead Cost
These are the indirect costs that the enterprise has incurred regardless of the production volume. Examples of such cost can be building maintenance cost, depreciation and administration cost.
Storage costs, selling costs, abnormal costs, administrative overheads, foreign exchange differences, and interest cost should not be included as inventory cost. [IAS 2.16 and 2.18]
While measuring the actual cost, the standard cost and retail methods can be used. In the standard technique, the value of inventory is calculated at the standard cost per unit while in retail technique, the relevant gross profit margin is deducted from the sales value of inventory. [IAS 2.21-22]
The specific cost is recorded for an individual item if it is non-interchangeable. [IAS 2.23]
The FIFO or weighted average cost formula is applicable to items that are interchangeable. [IAS 2.25]
According to First-In, First-Out method, the oldest purchased or manufactured inventory is supposed to be sold first and the newer ones remain unsold. While the weighted average cost formula is the total cost of inventory to total units of inventory.
For inventories with similar characteristics, the same cost formula can be used. Different cost formulas can be used for a group of inventories with different characteristics. [IAS 2.25]
Write Down To Net Realizable Value
Net realizable value is the estimated selling price excluding the cost of completion and other costs that were essential to making the sale. This should be recognized as an expense. Any reversal has to be recorded in the income statement for the period in which the reversal is done.
Recognition of Expenses
When the revenue is not recognized even after the inventories are sold, the carrying amount for such inventories will be considered as an expense. Write-down to NRV and any losses in inventory also come under expenses when they occur. It is mentioned in IAS 2.34.
The following disclosures are important to be done: [IAS 2.36]
- The accounting policies used by the entity for inventories.
- The carrying amount must be disclosed. It is usually classified as supplies, finished goods, work in progress and merchandise. Different entities can use different classifications according to their requirements.
- The cost of inventories that are recognized as expenses.
- Carrying amount of inventories that are held as securities.
- Any reversal amount.
- Any write-down of inventories.
The above mentioned are the guidelines set by IAS 2 in order to evaluate and classify the inventories. Different disclosures are necessary on the part of the entity to maintain transparency and consistency in reporting. These guidelines are important to determine the costs and which costs can be recognized as expenses.
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