Inventory

IAS 2 Inventories prescribes the accounting treatment for inventories. Its core principle is that inventories must be measured at the lower of cost and net realisable value (NRV).

Inventories are assets that are:

• Held for sale in the ordinary course of business (finished goods)
• In the process of production for such sale (work in progress)
• In the form of materials or supplies to be consumed in the production process or in rendering services (raw materials)

IAS 2 does NOT apply to:

• Financial instruments (covered by IFRS 9)
• Biological assets related to agricultural activity and agricultural produce at the point of harvest (IAS 41)
• Inventories held by commodity broker-traders measured at fair value less costs to sell (changes in fair value go to profit or loss)
• Work in progress arising under construction contracts (now under IFRS 15)

The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing inventories to their present location and condition.

Costs of purchase include:

• Purchase price of the goods
• Import duties and other non-recoverable taxes
• Transport, handling, and delivery costs (carriage inwards)
• Other costs directly attributable to the acquisition of finished goods, materials, and services

Trade discounts, rebates, and similar items are deducted from purchase cost.

Costs of conversion include:

• Direct costs: direct labour and other costs directly related to units of production
• Fixed production overheads: allocated based on normal capacity of the production facilities. Normal capacity is the production expected to be achieved on average over a number of periods under normal circumstances, taking into account planned maintenance. If actual production is abnormally low, the unallocated fixed overhead is recognised as an expense in the period (not added to unit cost). If production is abnormally high, the amount of fixed overhead allocated to each unit is reduced (so inventory is not overstated).
• Variable production overheads: allocated to each unit of production on the basis of actual use of production facilities

Costs excluded from inventory (recognised as expenses in the period incurred):

• Abnormal amounts of wasted materials, labour, or other production costs
• Storage costs (unless necessary as part of the production process before a further production stage)
• Administrative overheads that do not contribute to bringing inventories to their present location and condition
• Selling costs (e.g., advertising, delivery to customer, sales commissions)

IAS 2 permits two cost formulas for assigning costs to interchangeable (fungible) items of inventory:

First In, First Out (FIFO)

Weighted Average Cost

Specific Identification

LIFO is Not Permitted

Net realisable value (NRV) is defined as:

NRV = Estimated selling price in the ordinary course of business − Estimated costs of completion − Estimated costs necessary to make the sale

Inventories must be written down to NRV when NRV falls below cost. This typically occurs when:

• Goods are physically damaged or deteriorated
• Goods have become wholly or partially obsolete (e.g., superseded technology, out-of-fashion clothing)
• Selling prices have declined below cost
• The estimated costs of completion or selling have increased such that NRV falls below cost

Key rules:

• The assessment is performed on an item-by-item basis, or by groups of similar or related items — but NOT for an entire classification of inventory in aggregate. You cannot offset a gain on one product line against a loss on another unrelated line.
• The write-down to NRV is recognised as an expense in the period it occurs, normally within cost of sales.
• If NRV subsequently recovers (e.g., selling prices increase), the write-down can be reversed — but only up to the original cost. The reversal reduces cost of sales in the period of reversal.
• Raw materials held for use in production are not written down below cost if the finished goods in which they will be incorporated are expected to be sold at or above cost.

Entities use one of two systems to track inventory quantities and values:

Perpetual (continuous) system:

• Inventory records are updated in real time — every purchase and every sale/issue is recorded immediately
• The inventory balance and cost of sales are known at any point during the period
• Requires robust systems — typically computerised with barcode/RFID scanning
• Inventory losses (theft, damage, evaporation) are identified as discrepancies between book records and physical counts
• Cost of sales is calculated for each individual sale at the time of the transaction

Periodic system:

• Inventory records are updated only at the end of each accounting period when a physical count is performed
• During the period, all purchases are debited to a Purchases account (not directly to inventory)
• Cost of sales is calculated at period end using the formula:

Cost of Sales = Opening Inventory + Purchases − Closing Inventory

• Simpler to operate but provides no information about inventory levels during the period
• Inventory shrinkage, theft, or damage is not separately identified — it is absorbed into cost of sales

Under FIFO, both systems give the same closing inventory and cost of sales because the order of deemed issue is the same regardless of when the calculation is performed. Under weighted average, the two systems may give slightly different results (periodic average vs continuous/moving average).

A physical inventory count is essential to verify the existence and condition of inventory, regardless of whether a perpetual or periodic system is used. IAS 2 does not prescribe count procedures, but best practice and auditing standards (ISA 501) require robust controls.

Pre-count planning:

• Written count instructions issued to all counting teams
• Inventory areas tidied and organised — items clearly labelled and accessible
• Slow-moving, obsolete, or damaged items separately identified for NRV assessment
• Cut-off procedures established: goods received and dispatched near the count date must be correctly included or excluded. Goods received before the count but not yet recorded must be included. Goods dispatched before the count must be excluded.
• Movements of inventory should be minimised or suspended during the count where practicable

During the count:

• Counting typically performed by two-person teams: one counts, one records
• Pre-numbered count sheets or tags are used to ensure all items and areas are covered
• Systematic sequencing to prevent areas being missed or double-counted
• Supervisors perform spot checks by recounting selected items
• Third-party goods (e.g., goods held on consignment) must be excluded from the entity's inventory
• The entity's goods held at third-party locations must be separately confirmed and included

Post-count:

• All count sheets collected and checked for completeness (all sequential numbers accounted for)
• Quantities compared to book records (in a perpetual system) — discrepancies investigated
• Damaged, obsolete, or slow-moving items listed for management review and NRV assessment
• Final inventory valuation prepared: quantities × unit costs (using the entity's chosen cost formula)
• Adjustments posted to the accounting records for any discrepancies

For the auditor, attending the inventory count is a key procedure under ISA 501. The auditor observes the counting process, performs test counts, and inspects inventory condition.