IAS 2 Inventories

A primary issue in accounting for inventories is the amount to be recognised in the statement of financial position. The objective of IAS 2 is to prescribe the accounting treatment for inventories.  Inventories are assets:

1. held for sale in the ordinary course of business
2. in the process of production for such sale
3. in the form of materials to be consumed in the production process

Inventories are valued at the lower of cost and net realizable value so as not to overstate inventories and eventually profit. This is in line with the prudence concept which states that the accounts of a business should anticipate losses and not profits.

Example 1

A company has two items in inventory which require to be repaired before sale

What is the total inventory value of these items?

Item 1 =  $ 5 200

Item 2 = $ 2 200

Value of inventory = $ 7 4 00

Example 2

Inventory has been damaged. The inventory cost S 1200. It would have been sold for $ 1 800 when perfect. It can be sold for $ 1 700 if repairs are undertaken at $ 600. To replace the inventory would cost $ 1 000. At what value should the damaged inventory be shown in the final accounts?

Value of inventory = $ 1 700 - $ 600 = $ 1 100

According to IAS 2, the cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.  The net realizable value of inventories is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale.

If various batches of inventories have been purchased at different times during the year and at different prices, it may be impossible to determine precisely which items are still held at the year end. In such circumstances, IAS 2 allowed the following methods to be used

1. FIFO (First In First Out) – Items of inventory that were purchased first are sold first. Inventories are valued at the latest price.
2. AVCO (Average Cost) – The cost of inventories are determined by calculating an average price each time items are purchased.

IAS 2 does not allow the use of LIFO (Last In First Out) since it overstate inventory and profit.

Advantages FIFO (first in, first out)

• it is realistic, ie it assumes that goods are issued in order of receipt
• it is easy to calculate
• inventory valuation comprises the actual costs at which items have been bought
• the closing inventory valuation is close to the most recent costs
• it is one of the two methods which IAS 2, Inventories, allows companies to use
• acceptable for tax purposes

Disadvantages FIFO (first in, first out)

• costs at which goods are issued are not necessarily the latest prices, so cost of sales may not represent current prices
• in times of rising prices, profits are higher than with other methods (resulting in more tax to pay)
• the method is cumbersome as the list of different costs must be maintained

Advantages AVCO (average cost)

• over a number of accounting periods reported profits are smoothed, i.e. both high and low profits are avoided
• fluctuations in purchase costs are evened out so that issues per unit do not vary greatly
• it assumes that identical units, when purchased at different times, have the same value
• closing inventory valuation is close to current market values (in times of rising prices, it will be below current market values)
• the calculations can be computerised more easily than the other methods
• it is one of the two methods which IAS 2, Inventories, allows companies to use
• acceptable for tax purposes

Disadvantages AVCO (average cost)

• a new weighted average has to be calculated after each receipt, and calculations may be to several decimal places
• because they are averaged, issues and inventory valuation are usually at costs which never existed
• issues may not be at current costs and, in times of rising prices, will be below current costs