IAS 2 Inventories

IAS 2 prescribes the accounting treatment on inventories, especially on measurement and recognition of
inventories.

Definitions

1. Inventory: This is an asset held for sale in the ordinary course of business (not occasional sale). It also
includes asset in the process of production for such sale (WIP) or asset in the form of materials or
supplies to be consumed in the production process or in the rendering of services (raw materials).
2. Net realisable value: This is the estimated selling price in the ordinary course of business less the
estimated costs necessary to make the sale. It can also be referred to as fair value less costs to sale.
3. Fair value: This is the price that would be received to sell an asset or paid to transfer or settle a liability
in an orderly transaction between market participants at the measurement date.
4. Fixed production overheads: These are those indirect costs of production that remain relatively
constant regardless of the volume of production, eg, the cost of factory management and administration.
5. Variable production costs: These are those costs of production that vary directly, or nearly directly,
with the volume of production, e.g. direct materials and labour. Note direct material and direct labour
are not overheads but part of prime cost.
6. Conversion costs: These costs incurred in converting raw materials into finished goods.
7. Carrying amount: This is the amount that assets and liabilities are recognised in the statement of
financial position. For non-current assets, it represents their net book value.
8. Impairment loss: This is the amount by which the carrying amount of an asset exceeds its recoverable
value.

Examples of Inventories

a. Merchandise or Goods purchased and held for resale such as those in the super markets.
b. Consumables usually tangible items that are to be consumed in the production of goods or sundering of
services such as stationaries.
c. Production supplies such as petroleum products like oil
d. Finished goods produced.
e. Work in progress being produced.
f. Raw materials

Recognition of Inventory

Inventory sold during the reporting period: The inventory sold during the reporting period should be
recognised as expense (cost of sales) in the profit or loss at its carrying amount (i.e book value).

Unsold inventory as at the reporting date: The quantity of unsold inventory should be recognised as an asset
(current assets) in the statement of financial position at the lower or cost value and net realisable value (NRV).

NB: Whenever net realisable value (NRV) of inventory is lower than its cost value, it means that the inventory
had impaired in value. The impairment on inventory should be charged to cost of sales and also deducted from
inventory asset.

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Measurement of Inventory

a. At initial recognition

As at the time of acquisition (or production), inventory should be initial measured at cost. This represents its
purchase price plus all directly attributable costs incurred in getting the inventory ready for sale. But if there
was a delay between the time of purchase and the time of initial recognition, then the inventory would be
measured at the lower of cost and net realisable value.

Cost of inventory: This is the amount of cash or cash equivalents paid or the fair value of other consideration
given to acquire or produce an inventory as at the time of its acquisition or production. The cost of inventory
includes the purchase price and all directly attributable costs incurred in bring the item of inventory to its
present location and saleable condition. Simply put, cost of inventory includes all relevant cost incurred in
making the inventory available or ready for sale.

b. Subsequent to initial recognition

After the initial recognition, inventory should be measured at the lower of cost and net realisable value. That is,
the cost value of inventory should be compared with the net amount that would be realised from the sale of the
inventory, and the lower value should represent the value of the inventory. This is to ensure that inventory must
value at cost or below cost if net realisable value is less than cost.

The comparison of cost with net realizable value should, in principle, be carried out on an item-by-item basis.
However, if this is impracticable or impossible, groups of similar items may be considered together. It is
unacceptable to compare the total net realizable value of all inventories with their total purchase price or
production cost.

However, agricultural produce after harvest should be measured as follows:

At initial recognition, the agricultural produce after harvest should be measured in line with IAS 2

"Inventory" at at fair value less costs to sell. The fair value less costs to sell is the assumed cost of inventory
After the initial recognition, the agricultural produce after harvest should be measured in line with IAS 2
"Inventory" at the lower of cost and net realisable value.

Exception to the measurement rule

However, producers of agricultural products, forest products, minerals and mineral resources such as fuels, they
measure their inventory at net realisable values while in commodity dealers and brokers measure inventory
at fair value less cost to sell (e.g gold).

Cost of Inventories

The cost of inventories will consist of all costs of:

i. Purchase costs
ii. Delivery costs
iii. Costs of conversion
iv. Import duties and other non-refundable taxes
v. Transport, handling and any other cost directly attributed to the acquisition of finished goods,
services

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and raw materials.

vi. Trade discounts, rebates and other similar amount at source should be deducted.
vii. And any other cost incurred in bringing the inventories to their present location and condition

Discount or Rebates on Purchase of Inventory

Trade discounts

All trade discounts should be considered in deriving inventory cost. That is, all trade discounts should be
deducted in deriving inventory cost.

Cash discounts

These may or may not be considered depending on whether it was made available on the date of purchase or
not.

Cash discounts made available on purchase date

All cash discounts made available on the date of purchase should be deducted in deriving inventory cost even if
it not certain that the associated conditions would be met. This means that all discounts made available on
purchase date whether trade or cash discounts must be deducted in deriving inventory cost.

If the conditions were not met at the end of the discount period, the discount earlier deducted from inventory
cost would be forfeited and recognised as finance cost in the statement of profit or loss.

Accounting entries for forfeited discount

Dr Finance costs

Cr Payable

To record the cash discount recognised on purchase of inventory but later forfeited

Cash discounts made available after the purchase date

All cash discounts made available after the purchase date (ie after the purchase of inventory) should not affect
inventory value irrespective of whether the conditions would be met or not. Cash discounts made available after
purchase date should not be recognised until the conditions are met (i.e until the settlement is made). When the
conditions are met, such discounts should be recognised as an income (discount received) in the statement of
profit or loss.

Accounting entries

with cash discount made available after purchase date

Dr Payables ....... with cash discount made available after purchase date

Cr Discount received income....... with cash discount made available after purchase date

To record the cash discount from supplier for earlier settlement

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Costs That Will Not Be Included As Part Of Inventory Costs

i. A Storage costs (unless it relates to cost storing raw materials and work in progress before
production is completed)
ii. Abnormal amount of wasted materials or labour
iii. Administrative overheads that was not incurred in bringing the inventory to its present location and

Condition

iv. Advertisement costs

NB: Where inventory is considered as a qualifying asset, then the interest cost incurred on money borrowed to
acquire or manufacture or construct the inventory during the construction period should be capitalised and
added to inventory costs.

ACCOUNTING ENTRIES (FOR NON-INVENTORY COST ABOVE)

Dr Profit or loss

Cr Cash or bank (Payable for any amount outstanding)

To record the non-inventory cost to be expensed

SALES TAX OR VAT (ie Value Added Tax) INCURRED ON INVENTORY

Sales tax or value added tax (VAT) incurred on inventory are usually refundable or recoverable in nature and
should NOT be included as part of inventory cost.

This means that the VAT or sales tax value are expected to recovered back from the relevant Tax authority. In
most tax jurisdiction, the sales tax or VAT recoverable will be deducted from the sales tax or VAT received
from sales to customers, and settlement to (or from) the tax authority will be at net.

However, if sales tax or VAT is not refundable or recoverable (very rare), it means that the sales tax or VAT
will be included as part of the inventory cost.

ACCOUNTING ENTRIES

i. Where the VAT or sales tax is refundable or recoverable

Dr VAT (or sales tax) recoverable

Cr Cash or bank (Payable if the inventory was purchased on credit)

To record the refundable VAT or sales tax incurred on inventory purchased or manufactured

ii. Where the VAT or sales tax is NOT refundable or recoverable

Dr Inventory

Cr Cash or bank (Payable if the inventory was purchased on credit)

METHODS OF MEASURING OR DETERMINING THE COST OF INVENTORY AFTER INITIAL

Dr Inventory

IAS 2 recommends the following methods:

A. Measurement techniques

B. Specific actual cost

C. Actual cost based on cost formula

A. MEASUREMENT TECHNIQUES

This is basically a method to approximate cost of inventory for convenience and it is used when the items of
inventory are small in large quantity and it is difficult or impractical to ascertain the actual unit cost of
inventory. IAS 2 permits the following two methods:

Standard costs: This is the use of a predetermined cost or rate to measure inventory rather than its actual costs.
This method is mostly used by producers of large amounts of small items. The Standard costs should only be
used for period-end inventory valuation purposes and should be set in such that it will relate to actual costs
incurred during the period. This can be achieved by frequent updating of standards or adjusting for the recorded
variances.

Retail method: The retail method may often be used by retailers who sell a large number of relatively
homogeneous items with similar gross profit margins. The cost of inventories is determined by deducting
the average margin from the selling price of the inventories. Such average margins take into account any
reductions from the original selling price of items due to sales or other promotions. When the retail method is
used, average margins are often determined on a departmental basis.

The retail method is determined as follows:

Retail method Cost price

Opening inventory 60,000

Add purchases for the period 180,000

Total costs of inventory available for sale 240,000

Retail method (Selling Price)

Opening inventory 5,000

Add purchases for the period 245,000

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Retail costs or Sales value of inventory available for sale 320,000

Less sales for the period (ie at retail or sales value) (270,000)

Closing inventory at retail or sales value 50,000

Cost of closing inventory using retail method

Cost price of all goods available for sales

Retail or sales value of all goods available for sales X Retail or sales value of closing inventory

= N240.000

N320.0000 X N50,000 = N 37,500

B. SPECIFIC ACTUAL COST

This method measure inventory based on the specific actual cost of the inventory items are not interchangeable
and produced for segregated for specific projects. This method will be necessary if the inventories are
purchased or produced at different prices.

C. ACTUAL COST BASED ON COST FORMULA

This method is suitable when the inventory items are interchangeable and are not produced for specific projects.
This method is commonly used and IAS 2 recommends.

i. Weighted average cost (WAC)

IAS 2 states that an entity should use the same method in measuring all its inventories having similar nature and
use to the entity. For inventories with different nature or use, different valuation method may be justified. A
difference in geographical location of inventories (and in the respective tax rules), by itself, is not sufficient to
justify the use of different valuation methods.

WEIGHTED AVERAGE COST (WAC)

The weighted average cost method measures the cost each unit of closing inventory based on the weighted
average cost of all items purchased during the period including value of opening inventory. The weighted
average cost is calculated either on a periodic basis or on a perpetual basis as the inventory is received
depending on the inventory system of the reporting entity,

FIRST-IN FIRST-OUT (FIFO)

The FIFO method assumes that the items of inventory that were purchased or produced first are sold first.
Therefore, closing inventory constitute part of the most recent purchase (ie purchases made towards the end of
the period) and should be valued using the prices for the most recent purchases.

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Example 1 OPEYEMI Plc

On 1 January, 2023, OPEYEMI Plc had opening inventories of 34,000 units at a weighted average cost of N11
per unit, and made the following purchases during 2003:

Date of purchases Number of units Cost per Unit N Total Cost N

1 January 18,000 10 180,000

1 March 17,000 12 204,000

1 May 10,000 16 100,000

1 June 19,000 14 226,000

1 September 13,000 15 195,000

1 November 9,000 20 180,000

1 December 10,000 15 150,000

Total 96,000 1,335,000

The units of unsold goods (i.e closing inventory) as at 31 December, 2023 were 30,000 units.

Required

Determine the value of closing inventory as at 31 December, 2023

a. Weighted average cost method

USING WEIGHTED AVERAGE COST METHOD

Solution

Hints on weighted average cost method

i. Determine the units of closing inventory by subtracting total units sold from total units purchased
including opening inventory units (ignore since the closing inventory was given)
ii. Determine total costs of all inventory purchased during the period including the value of opening
inventory
iii. Determine the total units of all inventory purchased during the period including the units of opening
inventory
iv. Determine the weighted average cost per unit by dividing total costs by total units
v. Determine the value of closing inventory by multiplying the closing inventory units by weighted
aver- age cost per unit
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 Date of purchases Number of units Cost per Unit N Total Cost N

1 January (Opening Inventory) 34,000 11 374,000

1 January 18,000 10 180,000

1 March 17,000 12 204,000

1 May 10,000 16 160,000

1 June 19,000 14 226,000

1 September 13,000 15 195,000

1 November 9,000 20 180,000

1 December 10,000 15 150,000

Total 130,000 1,709,000

Weighted average cost per unit: Total units of all inventory including value of opening inventory

Total units of all inventory including units of opening inventory

N1, 709,000/130.000 units N13.15

Closing inventory value = Closing inventory units x Weighted average cost per unit

= 30, 000 units x N 13.15

=N394,500

FIFO METHOD

Tutorial Notes on FIFO Method

i. Determine the units of closing inventory by subtracting total units sold from total units purchased
including opening inventory units (ignore since the closing inventory was given.
ii. The closing inventory should be assumed to be part of the latest (most recent or last purchase). If the
closing inventory is more than the latest purchase, the next batch of purchase should be considered
and continued in that order.
iii. The cost per unit of the purchase batch or order represents the cost per unit of the associated closing
inventory.

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