Objective

The objective of IAS 2 is to prescribe the accounting treatment for inventories. A primary issue in
accounting for inventories is the amount of cost to be recognized as an asset and carried forward until
the related revenues are recognized. IAS 2 provides guidance for determining the cost of inventories and
for subsequently recognizing an expense, including any write-down to net realizable value (NRV). It
establishes the guidelines for the recording and presentation of inventories. It also provides guidance on
the cost formulas that are used to assign costs to inventories.

Scope
Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the
production process for sale in the ordinary course of business (work in process), and materials and
supplies that are consumed in production (raw materials).

The revision to IAS 2 has introduced 2 types of exclusions, those that are entirely outside the scope and
those that are outside the scope of measurement only.

The following inventories are excluded entirely:

 Work in process arising under construction contracts, including directly related service contracts
(IAS 11, Construction Contracts);
 Financial instruments (IAS 39, Financial Instruments);
 and Biological assets related to agricultural activity and agricultural produce at the point of
harvest or collection point (IAS 41, Agriculture).

The following are within the scope of the standard, IAS 2 does not apply to the measurement of
inventories held by:

 Producers of agricultural and forest products, agricultural produce after harvest, and minerals
and mineral products, to the extent that they are measured at NRV (above or below cost) in
accordance with well-established practices in those industries. When such inventories are
measured at NRV, changes in that value are recognized in profit or loss in the period of the
change.

Definition of inventory
The nature of inventories varies with the type of business. Inventories are:

 Assets held for sale in the ordinary course of business. For a retailer, these are items
that the business sells – its stock-in-trade. For a manufacturer, assets held for sale are
usually referred to as ‘finished goods’
 Assets in the process of production for sale (‘work-in-progress’ for a manufacturer)
 Assets in the form of materials or supplies to be used in the production process (‘raw
materials’ in the case of a manufacture.
Recording inventory
In order to prepare a statement of comprehensive income it is necessary to be able to
calculate gross profit. This requires the calculation of a cost of sales.
There are two main methods of recording inventory so as to allow the calculation of
cost of sales
1. . Periodic inventory system (period end system)
2. Perpetual inventory system

Each method uses a ledger account for inventory but these have different roles.

Periodic inventory system (period end

system)
A periodic inventory system records inventory purchases at specific time intervals and
doesn’t keep a continuous, real time record of inventory in stock or goods sold to
customers.

In other words, it’s exactly what it sounds like. A period inventory system records
inventory purchases and sales periodically throughout an accounting period. Purchase
and sale records are usually saved until a specific time interval and input in batches.

Perpetual inventory method

This is a system where inventory records are continuously updated so that inventory
values are always available.

A single account is used to record all inventory movements. The account is used to
record purchases in the period and inventory is brought down on the account at each
year-end. The account is also used to record all issues out of inventory. These issues
constitute the cost of sales.

When the perpetual inventory method is used, a record is kept of all receipts of items
into inventory (at cost) and all issues of inventory to cost of sales.

Each issue of inventory is given a cost, and the cost of the items issued is either the
actual cost of the inventory (if it is practicable to establish the actual cost) or a cost
obtained using a valuation method.

Each receipt and issue of inventory is recorded in the inventory account. This means
that a purchases account becomes unnecessary, because all purchases are recorded in
the inventory account.
All transactions involving the receipt or issue of inventory must be recorded, and at any
time, the balance on the inventory account should be the value of inventory currently
held.
 MEASUREMENT OF INVENTORY
The historical cost of inventory is usually measured by one of the following methods:

i. First in, first out (FIFO)

ii. Last In First Out (LIFO)

iii. Weighted average cost (AVCO)

First-in, first-out method of measurement (FIFO)

With the first-in, first-out method of inventory measurement, it is assumed that inventory is consumed
in the strict order in which it was purchased or manufactured. The first items that are received into
inventory are the first items that go out.

To establish the cost of inventory using FIFO, it is necessary to keep a record of:

 the date that units of inventory are received into inventory, the number
of units received and their purchase price (or manufacturing cost)
 the date that units are issued from inventory and the number of units
issued.

With this information, it is possible to put a cost to the inventory that is issued (sold or used) and to
identify the cost of the items still remaining in inventory.

Since it is assumed that the first items received into inventory are the first units that are used, it follows
that the value of inventory at any time should be the cost of the most recently-acquired.
 Last In First Out (LIFO) Method
Under LIFO the latest or more recent costs of products purchased (or produced) are the first costs
expensed as the cost of goods sold. This means that the costs of the oldest products will be reported as
inventory.

It is important to understand that while LIFO is matching the latest or most recent costs with sales on
the income statement, the company can be shipping the oldest physical units of product. In other
words, the flow of costs does not have to match the flow of the physical units. This is why LIFO is a cost
flow assumption or an assumed flow of costs. (If the costs flowing matched the physical units flowing, it
would be the specific identification method and there would be no need to assume a cost flow.)

Weighted average cost (AVCO) method

With the weighted average cost (AVCO) method of inventory measurement it is assumed that all units
are issued at the current weighted average cost per unit.
A new average cost is calculated whenever more items are purchased and received into store. The
weighted average cost is calculated as follows:

Items ‘currently in store’ are the items in store immediately before the new delivery is received.
The weighted average method calculates a new average cost per unit after each purchase. This is then
used to measure the cost of all issues up until the next purchase.

Net realisable value

Definition
Net realisable value is the estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale.

 Net realisable value is usually higher than cost. Inventory is therefore usually valued at cost.
 However, when inventory loses value, perhaps because it has been damaged, is now obsolete or
selling prices have declined, net realisable value will be lower than cost.

The cost and net realisable value should be compared for each separately-identifiable item of inventory,
or group of similar inventories, rather than for inventory in total.