IAS 2: Your Guide to Understanding Inventories

Welcome to our simplified guide on IAS 2, the International Accounting Standard that lays down the rules for how businesses account for their “inventories” – basically, all the stuff they have on hand to sell or use in making things to sell.

The Big Idea Behind IAS 2

The main goal of this standard is to tell companies how to account for their inventories. A key challenge is deciding how much of the cost of these items should be recognized as an asset (something the company owns) and kept on the books until it’s sold and generates income. IAS 2 provides guidance on figuring out that cost, how and when to record it as an expense, and even how to “write down” the value if it drops below what it can be sold for (its net realizable value). It also helps businesses choose the right methods for assigning costs to their inventories.

Who Does This Standard Apply To? (Scope)

IAS 2 applies to almost all inventories. However, there are a few important exceptions:

It DOES NOT apply to:

Financial instruments like stocks, bonds, or derivatives. These are covered by other standards (IAS 32 and IFRS 9).
Biological assets related to farming activities and farm produce at the point of harvest. These fall under IAS 41 Agriculture.

It also DOES NOT apply to the measurement of inventories held by:

Producers of farm and forest products, agricultural produce after harvest, and minerals and mineral products. This is specifically when these items are measured at their net realizable value based on common industry practices. If this is the case, any changes in their value are recognized directly in profit or loss. These inventories are only excluded from the measurement rules of IAS 2, not all its requirements. This often happens when sale is assured by a contract or government guarantee, or an active market exists with little risk of not selling.
Commodity broker-traders who value their inventories at fair value less costs to sell. For these businesses, changes in fair value less costs to sell are recognized in profit or loss. Broker-traders buy or sell commodities for others or themselves, often to profit from price fluctuations. Like the previous group, these inventories are only excluded from the measurement rules of IAS 2.

Key Terms You Should Know (Definitions)

Understanding these terms is crucial:

Inventories: These are assets a business holds for three main purposes:
- To be sold in the normal course of business.
- Being produced for such a sale.
- In the form of materials or supplies to be used in production or providing services.
- Examples: Merchandise a retailer buys to sell, land held for resale, finished goods, work-in-progress, and raw materials.
Net Realisable Value (NRV): This is the estimated selling price of your inventory in normal business operations, minus the estimated costs to finish the product and the estimated costs needed to make the sale. It’s a value specific to your company.
Fair Value: This is the price you would receive to sell an asset (or pay to transfer a liability) in an orderly transaction between market participants at a specific date. Unlike NRV, fair value is not specific to your company; it reflects the market. Important: NRV for inventories might not be the same as fair value less costs to sell.

How We Value Inventories (Measurement)

The fundamental rule is: Inventories must be measured at the lower of their cost and their net realisable value.

What Goes Into the “Cost of Inventories”?

The cost of inventories includes everything it takes to bring them to their current location and condition.

Costs of Purchase:
- This covers the purchase price, import duties, and other taxes that the company won’t get back from the tax authorities.
- It also includes transportation, handling, and any other costs directly related to acquiring the goods, materials, or services.
- Discounts are deducted! Trade discounts, rebates, and similar items reduce the purchase cost.
Costs of Conversion:
- These are the costs involved in turning materials into finished products.
- Direct labor is a clear example.
- They also include a systematic allocation of both fixed and variable production overheads.
  - Fixed Production Overheads: These indirect costs don’t change much, regardless of how much you produce (e.g., depreciation of factory buildings, rent, factory management salaries).
    - Their allocation to products is based on the normal capacity of the production facilities (what’s expected to be produced on average over time).
    - If production is low or the plant is idle, the amount of fixed overhead per unit isn’t increased; unallocated overheads are expensed.
    - If production is abnormally high, the fixed overhead per unit is decreased so that inventory isn’t valued above its true cost.
  - Variable Production Overheads: These indirect costs change directly with the volume of production (e.g., indirect materials, indirect labor). They are allocated based on the actual use of the production facilities.
- Joint Products & By-Products: If a production process yields more than one product (like a main product and a by-product), and conversion costs can’t be easily identified for each, they’re allocated on a fair and consistent basis (e.g., based on relative sales value). Small by-products are often measured at NRV, and that value is deducted from the main product’s cost.
Other Costs:
- Only other costs incurred to bring inventories to their current location and condition are included.
- For example: Some non-production overheads or the costs of designing products for specific customers might be included.

What Costs Are Excluded from Inventory Cost?

These are treated as expenses immediately:

Abnormal amounts of wasted materials, labor, or other production costs.
Storage costs, unless they are necessary as part of the production process before a further production stage.
Administrative overheads that don’t help bring the inventories to their current location and condition.
Selling costs.
Generally, borrowing costs are not included, except in limited circumstances identified by IAS 23 Borrowing Costs.
If you buy inventory on deferred payment terms and there’s a financing element (like paying more than the normal credit price), that extra amount is recognized as interest expense.

Agricultural Produce Cost

For agricultural produce harvested from biological assets (covered by IAS 41), the cost for IAS 2 purposes is its fair value less costs to sell at the point of harvest.

Measuring Cost: Simplified Techniques

For convenience, companies can use techniques like:

Standard Cost Method: This uses pre-determined costs based on normal levels of materials, labor, and efficiency. These are regularly reviewed.
Retail Method: Commonly used in retail for many fast-moving items with similar profit margins. The cost is estimated by reducing the sales value by the appropriate gross margin percentage.

How We Assign Costs to Inventory (Cost Formulas)

This part determines how we figure out the cost of items sold versus items remaining in inventory.

Specific Identification:
- Used for items that are not ordinarily interchangeable or are produced for specific projects.
- You identify the actual cost for each specific item.
- However, it’s not appropriate for large numbers of interchangeable items, as it could be used to manipulate profit or loss.
First-In, First-Out (FIFO) or Weighted Average Cost:
- For most other inventories, companies must use either FIFO or the weighted average cost formula.
- FIFO (First-In, First-Out): This assumes that the oldest inventory items purchased or produced are the first ones sold. So, the inventory remaining at the end of the period consists of the most recently acquired items.
- Weighted Average Cost: Here, the cost of each item is determined by averaging the cost of similar items available at the beginning of the period and those purchased or produced during the period. This average can be calculated periodically or as new shipments arrive.
- Consistency is Key: A company must use the same cost formula for all inventories that have a similar nature and use. Different formulas might be justified for inventories with a different nature or use (e.g., in different operating segments). However, just being in a different geographical location or having different tax rules is not enough to justify different formulas.

When Inventory Value Drops (Net Realisable Value)

Sometimes, the original cost of inventory might not be recoverable. This happens if:

Inventories are damaged.
They’ve become completely or partially obsolete (outdated).
Their selling prices have fallen.
The estimated costs to complete them or sell them have increased.

The practice of “writing down” inventories to their net realisable value (NRV) means we ensure assets aren’t carried at a higher value than what’s expected to be earned from their sale or use.

Item by Item: Inventories are usually written down to NRV on an individual item basis.
Grouping: In some cases, it might be okay to group similar items (e.g., items in the same product line with similar uses, produced/marketed in the same area, and hard to evaluate separately).
No Broad Classifications: It’s not appropriate to write down inventory based on broad classifications like “all finished goods” or “all inventory in one segment”.

Estimating NRV

Estimates are based on the best available evidence at the time, including price or cost changes after the period end that confirm existing conditions.
The purpose for which the inventory is held is also considered. For example, inventory held for firm sales contracts is valued based on the contract price. Excess inventory beyond firm contracts is based on general selling prices.
Raw materials and supplies used in production are not written down below cost if the finished products they’ll be part of are expected to sell at or above cost. However, if material price drops indicate the finished product’s cost will exceed NRV, then the materials are written down to NRV (replacement cost might be the best measure then).

Reversing a Write-Down

You must reassess NRV in each new period.
If the reasons for a previous write-down no longer exist, or if NRV clearly increases due to changed economic circumstances, the write-down can be reversed.
The reversal is limited to the amount of the original write-down, so the new carrying amount is still the lower of cost and the revised NRV. For instance, if an item was written down because its selling price dropped, and then its selling price goes up again, the write-down can be reversed.

When Inventory Becomes an Expense

When inventories are sold, their carrying amount (their value on the books) is recognized as an expense in the same period that the related sales revenue is recognized. This is often called “cost of sales”.
Any amount of write-down of inventories to NRV and any losses of inventories are also recognized as an expense in the period they occur.
If a write-down is reversed (because NRV increased), that reversal is recognized as a reduction in the amount of inventory expense for that period.
Sometimes, inventories are used to create other assets (e.g., inventory used to build a company’s own factory). In these cases, the inventory’s cost is recognized as an expense over the useful life of that new asset.

What Companies Must Tell You (Disclosure)

For transparency, financial statements must disclose:

The specific accounting policies used for inventories, including the cost formula (FIFO or weighted average).
The total value of inventories and how they are classified (e.g., merchandise, raw materials, work in progress, finished goods).
The carrying amount (value on the books) of inventories measured at fair value less costs to sell.
The amount of inventories recognized as an expense during the period (cost of sales).
The amount of any write-down of inventories recognized as an expense during the period.
The amount of any reversal of a write-down that reduced inventory expense during the period.
The reasons (circumstances or events) that led to the reversal of a write-down.
The carrying amount of inventories that have been pledged as security for liabilities (e.g., used as collateral for a loan).