IAS 2 Inventories: Accounting Treatment and Rules

International Accounting Standard 2 (IAS 2) provides the global benchmark for the accounting treatment of inventories for entities following International Financial Reporting Standards (IFRS). The standard prescribes how companies should account for these assets to ensure financial statements accurately represent their value. IAS 2 offers guidance on determining inventory cost, its subsequent recognition as an expense, and how to handle any write-downs in value. It also specifies the cost formulas that can be used to assign costs to inventory.

Scope of the Standard

IAS 2 defines inventories as assets held for sale in the ordinary course of business, in the process of production for such a sale, or as materials or supplies to be consumed in production. This definition covers three main categories: finished goods ready for sale, work-in-progress goods, and raw materials waiting to be used in production. For example, a car dealership’s lot of new vehicles are finished goods, while a bakery’s stock of flour and sugar are raw materials.

The standard does not apply to certain assets, including financial instruments governed by IFRS 9 or biological assets covered by IAS 41. It also excludes inventories held by producers of agricultural, forest, or mineral products if they are measured at net realizable value according to industry practices. Commodity broker-traders who measure their inventories at fair value less costs to sell are also excluded from the measurement requirements of IAS 2.

The Principle of Measurement

The measurement principle in IAS 2 is that inventories must be recorded at the lower of cost and net realizable value (NRV). This rule ensures that inventory is not valued at an amount greater than what the company expects to realize from its sale or use, preventing the overstatement of assets and profits. The assessment is performed for each item of inventory, though grouping similar or related items is sometimes appropriate.

Net realizable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and costs necessary to make the sale. For instance, if a clothing retailer has a dress that cost $100 and expects to sell it for $150, but will incur $10 in shipping and sales commissions, the NRV would be $140. Since the cost of $100 is lower than the NRV of $140, the dress would remain valued at its cost. If the dress went out of style and its expected selling price dropped to $90, its NRV would become $80 ($90 – $10), and the company would have to write down the inventory value from its cost of $100 down to $80.

Determining Inventory Cost

The cost of inventory includes all costs of purchase, costs of conversion, and other costs incurred to bring the inventory to its present location and condition. This represents the total investment made to acquire or produce the asset.

Costs of purchase begin with the price paid to the supplier and also include import duties and other non-refundable taxes. Any transportation and handling costs directly related to acquiring the goods are added to the cost. Conversely, any trade discounts or rebates received from the supplier are deducted from the purchase price.

Costs of conversion apply to manufactured inventories and are the expenses related to turning raw materials into finished goods. These costs include direct labor and a systematic allocation of production overheads. These overheads are broken down into variable overheads, which change with production volume, and fixed overheads, such as factory rent, which remain constant.

IAS 2 permits two cost formulas for interchangeable inventory items: the First-In, First-Out (FIFO) method and the Weighted-Average Cost method. Under FIFO, it is assumed that the first units purchased are the first ones sold, so ending inventory is based on the prices of the most recent purchases. The Weighted-Average Cost method calculates an average cost for all similar items in inventory. IAS 2 explicitly prohibits the use of the Last-In, First-Out (LIFO) method.

Recognizing Expenses

The value of inventory recorded as an asset is eventually recognized as an expense on the income statement. The timing of this recognition impacts a company’s reported profitability. IAS 2 outlines two main circumstances under which the carrying amount of inventory is expensed.

The most common scenario is when inventory is sold. When a company sells its products, the carrying amount of that inventory is transferred from an asset to an expense in the same period that the related sales revenue is recognized. This expense is widely known as the cost of goods sold (COGS).

A second scenario for expense recognition occurs when inventory is written down. If the NRV of an inventory item falls below its recorded cost, the company must recognize the difference as an expense immediately. For example, if inventory costing $5,000 is determined to have an NRV of only $4,000, a $1,000 expense for the write-down is recognized in the current period.

In some situations, the value of inventory may recover after a write-down. IAS 2 permits the reversal of a previous write-down if the circumstances that caused it no longer exist or if there is clear evidence of an increase in NRV. The amount of the reversal is limited to the amount of the original write-down. This reversal is recognized as a reduction in the amount of inventories recognized as an expense during the period.

Required Financial Disclosures

To provide transparency, IAS 2 mandates specific disclosures in the notes to the financial statements. These disclosures offer insight into the valuation methods and composition of a company’s inventory. A company must first disclose the accounting policies it has adopted for measuring inventories, including the cost formula used, whether it is FIFO or Weighted-Average Cost.

The financial statements must also show the total carrying amount of inventories, as well as a breakdown of this amount into classifications appropriate for the entity, such as merchandise, raw materials, work in progress, and finished goods. Other required disclosures include:

• The total amount of inventories recognized as an expense during the period (cost of goods sold).
• The amount of any write-down of inventories that was recognized as an expense.
• The amount of any reversal of a previous write-down, along with the circumstances that led to it.
• The carrying amount of any inventories pledged as security for liabilities.