IAS 2

INVENTORY

Definition
Defined as assets Held for sale in the ordinary course of business
In the process of production for such sale (i.e work in progress), or
In the form of materials or supplies to be consumed in the production process
or in the rendering of services (i.e. raw materials & consumables
Inventories are not only items held on sale
Not all items held on sale are inventory
Spare parts expected to be used for one accounting period or less are regarded
as inventory, & major parts expected to be used for more than one period are
regarded as PPE.
Intangibles can also be inventory e.g. computer software developed for resale
or unbilled work of a service provider.

Scope
IAS 2 focuses on:
Calculation of cost of inventory
Recognition of this cost as expense
Recognition of other expenses associated with inventory

Exclusions
Long term construction contracts in progress
Financial instruments
Agricultural produce at the point of harvest
Biological assets related to agricultural activity

Exclusions
The following items are only excluded from
measurement:
Mining, forestry & agricultural industry provided that
well established practice exists in those industries to
measure goods at NRV at certain stages of production.
Commodity broker-traders who measure their inventory
at FV less costs to sell with changes recognized in profit
or loss

Recognition & derecognition

Recognised as an asset where It is controlled by the entity
As a result of a past event (acquisition or production thereof)
From which probable future benefits will flow, and
It has a cost which can be measured reliably

Recognise inventory on the date when risks & rewards of ownership transfer to
the entity, usually delivery date but there are exceptions like FOB
arrangements

On derecognition, recognize carrying amount as expense (part of cost of sales)

(derecognition & revenue recognition should coincide).

Measurement
Inventory is initially measured at cost- total cost of
purchase, plus conversion costs & other costs incurred
in bringing inventory to to its present location &
condition
Subsequently measured at the lower of cost and net
realizable

Purchase costs
Comprise purchase price, includes import duties, non
recoverable purchase taxes, transport & handling costs
& any other costs directly attributable to the acquisition
of raw materials, merchandise & consumables.
Trade discounts or cash discounts are deducted from
the costof inventories

Example
X Ltd buys inventory for $115 000 (VAT inclusive) and
pays cash in order to make use of a 5% cash discount
offered by the supplier. The inventory is transferred to X
Ltds premises by train, and the total railage amounts to
$500 (VAT exclusive). Costs incurred to insure the
inventory while in transit, amounts to $900 (VAT
exclusive)
Calculate the cost of purchase of inventory.

Rebates
Representing refund of part of the purchase price should
be estimated at the date of purchase of inventory &
deducted from the cost of inventory
Representing refund of selling expenses incurred should
not affect the cost of inventory.

Example
X Ltd sells shoes & these shoes are bought from B Ltd at
$300 per pair. B Ltd has agreed to grant X Ltd a rebate
of 2% on all purchases if X Ltd buys at least 200 pairs
during a period of twelve months. The rebate will be
settled in cash at the end of the twelve month period.
How much should the inventory be recognized at?

Settlement discounts
Should be estimated at date of purchase and deducted
from the cost(if intended to be settled within the time
otherwise expense the whole amount)

Deferred settlement terms

If inventory is purchased on deferred settlement terms, discount future
cashflows back to a present value which should be taken as the cost.
Difference between this present value & amount actually paid is interest over
the period of the financing.
Example
X Ltd buys inventory, with a cost of $250 000 from B ltd. Due to cash flow
problems experienced by X Ltd, it is agreed that the amount due will be settled
after nine months, even though the normal credit period granted by B Ltd is only
three months. A fair discount rate is 12% per annum compounded monthly.

PV of $250 000 discounted over a period of 9 months, compounded monthly is

$228 585.
How much is the cost of the inventory

Conversion costs
Manufacturing or processing costs including normal spillages that relate to conversion of
raw materials into finished goods.
Includes direct costs e.g direct labour including their fringe benefits & pension
Also includes indirect costs(indirect fixed production overheads & indirect variable
production overheads)
It is mandatory to include fixed production overheads in the cost of inventory
Indirect variable overheads e.g indirect materials, water consumption & electricity is based
on actual use of production resources
Fixed production overheads e.g. factory rental, salaries of factory supervisors, insurance of
plant & depreciation should be allocated to inventory based on normal capacity of
production.
In periods of low production do not increase the fixed costs allocate, difference is charged
to cost of sales
In periods of high productivity, decrease the cost per unit

Example
Assume that fixed production overheads amount to $100
000 and normal capacity equals 10 000 units. The actual
production during the year amounted to only 7 000 units.

Allocate the overheads.

If actual production is 15 000 units allocate only $100 000

to cost of inventory

Example

Saudi Ltd manufactures sunglasses. The following info applies:

$20 000 of raw materials were available on 1 Jan 2010 (20 000kgs)
$40 000 of raw materials were purchased during jan 2010 (40 000kgs)
40% of raw materials available during Jan 2010 were used during jan 2010
Depreciation of $50 000 is incurred during Jan 2010 (80% of which relates to
factory machinery and 20% of which relates to office equipment). The machinery
was used 70% of the time in manufacturing inventory and the balance of the
time, the machinery was idle.
Wages of $100 000 were incurred & paid during Jan 2010 (80% related to factory
workers, 6% related to cleaning staff operating in the factory, 4% related to
cleaning staff operating in the admin offices).
Electricity of $62 000 was incurred and paid during Jan 2010. All of this related to
the factory operations.
There was no opening balance of WIP on 1/1/2010. 70% of WIP was complete by
31/1/2010 (representing 10 000 complete units)
There was an opening balance of $30 000 of finished goods on 1/1/2010
(representing 3 000 units). 7 000 units were sold during Jan 2010.

Joint products
Separate joint conversion costs based on relative sales value either at the
point of separation or at completion

Example
X Ltd manufactures diet supplements, including Omega 3 & Omega 6
capsules. The basic ingredient for both of these capsules is marine oil, which
costs R36 per litre. A machine is used to extract the Omega 3 & Omega 6
from the marine oil. The depreciation on the machine amounts to $1 000per
day, while the machine operator is paid $200 per day. The machine can
process 10 litres of marine oil in one day. One litre of marine oil is used to
produce ten Omega 3 capsules and eight Omega 6 capsules. The selling
price per capsule amounts to $8 for Omega 3 and $12 for Omega 6

By products
Products that emerge incidentally from the production process & have minor
sales value. They are measured at NRV & deducted from the cost of the main
product.

Example

X Ltd is a supplier of canned meats. Ten kgs of raw material is required to

produce 20 cans of processed meat. The raw meat costs $20 per kg, while the
conversion costs amount to $10 per kg. During the canning process all visible fat
is removed from the raw meat, after which it is sold to a dog food manufacturer,
at a price of $5 per kg. Ten kgs of raw meat usually have only 05kgs of fat.

Calculate the cost of the processed meat

Other costs
Include:
Costs to design a product for a specific customer
Amortization of development costs relating to specific product
Restoration/rehabilitation costs incurred as a result of manufacturing of inventory during a specific
period
Packaging costs incurred to prepare inventory for sale and
Borrowing costs incurred on inventory that is a qualifying asset

Costs excluded
Abnormal amounts of waste incurred in the production process
Impairment losses on machinery & equipment used in manufacturing process e.g. spillages, labour
costs during strikes & abnormal machine breakdowns)
Costs to distribute & transport goods to customers, and
Selling expenses, advertising costs, general administration overheads & storage costs(unless relating
directly to production)

Example
X Ltd employs 10 factory workers at a rate of $15 per
hour. These employees were on strike for one entire
month, during which production ceased completely.
After negotiations with the trade union, X Ltd agreed to
pay these workers a total amount of $15 000 for the
month during which they were on strike. The total wage
bill in respect of these employees amounted to $280
000 for the year.

What is the cost of the inventory?

Subsequent measurement
Net realizable value (NRV)
Inventory is measured at the lower of cost or NRV
If future net revenue expected to be generated by the sale of inventory on hand is less than cost
of that inventory, then the inventory should be written down.
Expected future revenue should take into account costs of selling e.g marketing costs,
distribution costs, packaging costs and sales commissions.
If inventory is damaged, obsolete, selling prices have declined, estimated costs to make the sale
have increased or to estimated costs of completion have increased, inventory must be written
down.
NRV is estimated selling price in the ordinary course of business less estimated costs of
completion & estimated costs necessary to make the sale.
Inventory should be written down on an item by item basis but however grouping of items that
relate to the same product line, same purpose, marketed in a similar geographical area & cannot
be practically evaluated separately is allowed.
Estimates of NRV are based on evidence at year-end

Example
Inventory with a cost of $200 per unit will be sold at a
price of $180 per unit in terms of an existing contract.
Similar products are selling at $210 per unit in the open
market. The contract requires delivery of 10 000 units.
At year-end, the company had 10 100 units on hand.

Calculate the carrying amount of the inventory.

Excess raw materials on hand- NRV is based on the

selling price

 Reversal of write downs

Assess NRV each accounting period

Write downs may be reversed limited to the amount of the original write down.

Cost formulas

Specific identification
Specific costs to identifies inventory
The most accurate method
Appropriate for goods that are not ordinarily interchangeable & goods produced & segregated.
Difficult to implement with high volumes

 First-in-first-out
Used where items are interchangeable
Goods produced/purchased first are sold first

Example
On 1 Jan 2001 A Ltd buys 1000 units of product X at $10 per unit. At 1
Sept 2001 the company buys another 500 units of product X at $12
per unit. At 31 December(year-end)600 units of product X were on
hand.
Calculate the value of closing inventory

 Weighted average
Used where items are interchangeable
Cost of item is determined from the weighted average of the cost of similar items at the start of the period &
cost of similar items purchased or produced during the period.
Average calculated on a periodic basis e.g. monthly or when each new shipment is received

Example
On 1 Jan 2001 A Ltd buys 1000 units of product X at $10 per unit. At 1 Sept 2001 the company buys another
500 units of product X at $12 per unit. At 31 December(year-end)600 units of product X were on hand.
Calculate the value of closing inventory.

Weighted average method is split into two:

Weighted average-period basis(average for purchases for the whole year)
Weighted average-moving basis(update average on new purchases received)

 Consistency
Same cost formula should be used for all inventories having a similar
nature & use
Diff in geographical locations doesnt justify use of diff formulas

Techniques for the measurement of cost

Standard cost
Inventory valued at standard costs established by management
expected costs, level of operations & operational efficiency
Useful if they consistently approximate results obtained by historical
cost

 Retail method

Average profit margin is deducted from selling price of inventory to arrive at a reasonable estimate of
cost

Service providers
Inventories include costs for which related revenue hasnt been recognized i.e. direct labour &
attributable overheads. Exclude profit, sales & administration staff costs
There will be no inventory accounted for if revenue is accounted for based on costs incurred /total
estimated costs.

Example
X Ltd renders accounting services to Y Ltd. A fee of $50 000 was negotiated for these services. It is
expected that it will take 80 hours to complete the accounting services of which 30 hours were spent
in year 1. The total expected costs to render these services amount to $40 000 of which $20 000 was
incurred in year 1.

Financial statement Presentation

Statement of Financial Position
Total carrying amount of inventories

Statement of profit or loss and other comprehensive income

Amount of inventories recognized as expense

Notes
Accounting policies
Carrying amount in classifications appropriate to entity
Carrying amount of inventory carried at FV less costs to sell(in respect of commodity broker-traders)
Carrying amount of inventory pledged as security
Amount reversed on previous write downs
Circumstances leading to reversal of previous write downs
Amount of write downs recognized as expense