Background

IAS 2 provides guidance for determining the cost of inventories and the subsequent recognition of the cost as an expense, including any write-down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories.

The reissued version of IAS 2 was issued in 2003 December and it will be applicable to annual periods starts on or after 1 January 2005.

Objective

The objective of this Standard IAS 2 is to prescribe the accounting treatment for inventories. A primary issue in accounting for inventories is the amount of cost to be recognised as an asset and carried forward until the related revenues are recognised. This Standard provides guidance on the determination of cost and its subsequent recognition as an expense, including any write‑down to net realisable value. It also provides guidance on the cost formulas that are used to assign costs to inventories.

Scope

This Standard is applicable to each type of inventories, EXCEPT few of the following:

(a) financial instruments (as described under IAS 32 Financial Instruments: Presentation and IFRS 9 Financial Instruments); and

(b) biological assets related to agricultural activity and agricultural produce at the point of harvest (refer IAS 41 Agriculture).

The Standard will NOT apply to the recognition of inventories held by:

(a) Agricultural and forest products producer, agricultural produce which arise post harvesting, and minerals and mineral products, upto the amount which calculated at net realisable value (NRV) according to well‑established practices in the related industries. At the time when those inventories are measured at net realisable value, changes in that value are recognised in profit or loss.

(b) Any commodity brokers who recognize their inventories at fair value minus selling costs, changes in fair value minus selling costs are recognised in profit or loss in the period of the change.

The inventories described in point-a (agricultural and forest products producer) are measured at net realizable value at certain stages of production. It happens, for instance- when agricultural crops have been harvested or minerals have been extracted and sale is certain under a forward contract or government guarantee or when an active market exists and there is an insignificant risk of failure to sell. These inventories shall be excluded from only the measurement requirements of this Standard.

Broker traders are those who buy or sell commodities for others or on their own account. The inventories mentioned to in point-b (commodity broker) are primarily acquired with the purpose of selling in the near future and generating a profit from variations in price or broker‑traders margin. The cases wherein these inventories are recognized at fair value minus selling cost, they are excluded from only the measurement requirements of this Standard.

Key definitions

Net realisable value

This is the estimated selling price in the ordinary course of business minus the estimated costs of completion and the estimated costs necessary to make the sale.

Fair value

The price which will be received from sell of asset or transfer of a liability in an orderly transaction between market participants at the measurement date. (refer IFRS 13 Fair Value Measurement)

Inventories are assets

In the following cases: -

(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

Measurement of inventories

Inventories shall be measured at the lower of cost and net realisable value.

Cost of inventories

The cost of inventories shall comprise of following:

·       costs of purchase

·       costs of conversion and

·       other costs incurred in bringing the inventories to their present location and condition.

What is Cost of purchase? – It comprises of purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase.

What is Cost of conversion? - The conversion cost of inventories includes costs directly pertains to the units of production, like direct labour. This should also include a orderly allocation of fixed and variable production overhead which was incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings, equipment and right‑of‑use assets used in the production process, and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials and indirect labour.

What is Other costs? - 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. For example, it may be appropriate to include non‑production overheads or the costs of designing products for specific customers in the cost of inventories

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred are:

(a) abnormal amounts of wasted materials, labour or other production costs;

(b) storage costs, unminus those costs are necessary in the production process before a further production stage;

(c) administrative overheads that do not contribute to bringing inventories to their present location and condition; and

(d) selling costs.

Cost of agricultural produce harvested from biological assets - In accordance with IAS 41 Agriculture inventories comprising agricultural produce that an entity has harvested from its biological assets are measured on initial recognition at their fair value minus costs to sell at the point of harvest. This is the cost of the inventories at that date for application of this Standard.

Techniques for the measurement of cost - Techniques for the measurement of the cost of inventories, such as the standard cost method or the retail method, may be used for convenience if the results approximate cost. Standard costs take into account normal levels of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in the light of current conditions.

Cost formulas - The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs.

The cost of inventories, other than those dealt in above, shall be assigned by using the first‑in, first‑out (FIFO) or weighted average cost formula. An entity shall use the same cost formula for all inventories having a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may be justified.

Net realisable value (NRV)

NRV is the estimated selling price in the ordinary course of business minus the estimated costs of completion and the estimated costs necessary to make the sale.

The cost of inventories may not be recoverable in following cases, if:

·       inventories are damaged

·       wholly or partially obsolete

·       selling prices have declined.

The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased. The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.

Recognition as an expense

When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. The amount of any write‑down of inventories to net realizable value and all losses of inventories shall be recognised 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 realisable value, shall be recognised as a reduction in the amount of inventories recognized as an expense in the period in which the reversal occurs.

Disclosure

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 minus costs to sell;

(d) the amount of inventories recognised as an expense during the period;

(e) the amount of any write‑down of inventories recognised as an expense in the period in accordance with paragraph 34;

(f) the amount of any reversal of any write‑down that is recognised as a reduction in the amount of inventories recognised as expense in the period in accordance with paragraph 34;

(g) the circumstances or events that led to the reversal of a write‑down of inventories in accordance with paragraph 34; and

(h) the carrying amount of inventories pledged as security for liabilities.