International Accounting Standards 2 (Inventories)
The objective of this standard is to prescribe the accounting treatment for inventories. The IAS 2 applies to all inventories except:
a) Work in progress arising under construction contracts including directly related service contracts (covered by IAS 11 Construction contracts )
b) Financial instruments (IAS 32 financial instruments, presentation and IFRS 9 financial instruments)
c) Biological assets related to agricultural activity and agricultural produce at the point of harvest
It should be noted that the standard does not apply to the measurement of inventories held by :
a) Producers of agricultural and forest products, agricultural produce after harvest, and mineral products, to the extent that they are measured at net realizable value in accordance with well established practices in those industries.
b) Commodity broker- traders who measure their inventories at fair value less costs to sell.
Measurement of Inventories
Inventories shall be measured at the lower of cost and net realizable value. Cost of inventories are all costs of purchase , costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Let us now break down the three costs mentioned above:
1) Costs of purchase: The cost of purchase would comprise the purchase price, import duties and other taxes and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services.
2) Cost of Conversion: Cost of conversion can simply be defined as the prime cost (direct material, direct labor, direct expenses) + Manufacturing overhead. That is the costs used to turn raw material or semi finished goods into finished goods.
The allocation of fixed production overheads to the cost of conversion is based on the normal capacity of the production facilities.
It should be noted that when a production process results in more than one product being produced simultaneously, and the costs of conversion of each product is not separately identifiable; they are to be allocated between the products on a rational and consistent basis.
3) Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition.
Techniques for Measuring Costs
The standard cost or retail method may be used to measure costs. The standard cost method entails using a set benchmark on normal capacity in labor and material usage to measure costs, which may be changed in current conditions.
Retail method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods.
The last in first out method (LIFO ) of cost measurement for reporting is not allowed under the IAS 2. The lifo is a method whereby it is assumed that items of inventory that were purchased last were sold first.
Under the IAS 2 the formulas allowed are the first- in –first out method or the weighted average cost formula. When inventories are sold, the carrying amount of these inventories shall be recognized as an expense in the period in which the related revenue is recognized. The amount of any write-down of inventories to net realizable value and all losses of inventories shall be recognized as an expense in the period the write-down or loss occurs.
The amount of any reversal of any write down of inventories, arising from an increase in net realizable value shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.
The financial statements shall disclose:
a) The accounting policies adopted in measuring inventories including the cost formula used.
b) The total Carrying amount of inventories and the carrying amount in classifications appropriate to the entity.
c) The carrying amount of inventories carried at fair value less costs to sell.
d) The amount of inventories recognized as an expense during the period.
e) The amount of any write down of inventories recognized as an expense in the period.
f) The amount of any reversal of any write-down that is recognized as expense to the period.
g) The circumstance or events that led to the reversal of a write- down of inventories
h) The carrying amount of inventories pledged as security for liabilities.
Abbas A Mirza., Graham Holt., Liesel Knorr., Wiley IFRS: Practical Implementation Guide and Workbook
Dieter Christian., Nobert Ludenbach., IFRS Essentials