BBFA 2064 FINANCIAL ACCOUNTING FRAMEWORK

IAS 2 / MFRS 102 Inventories

Study guide:
1. Describe and apply the principles of inventory valuation.

1. Introduction
The objective of IAS 2 is to prescribe the accounting treatment for inventories. It
provides guidance for determining the cost of inventories and for subsequently recognising
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.

Inventories (sometimes called stocks) have a direct impact on a company’s gross profit
and it is usually a material item in any company’s accounts.

They are presented under current assets in the SOFP.

2. Definition
Inventories are assets:

(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 material/supplies to be consumed in the production process or in the
rendering of services.

Inventories can include:-

- Goods purchased and held for resale
- Finished goods produced
- Work in progress produced
- Raw materials (materials and supplies waiting use in the production process)
- Consumable (such as oil)

Fair value is the price that would be received to sell an asset or paid to transfer a liability
in an orderly transaction between market participants at the measurement date.

3. Measurement
IAS 2 states that inventories should be measured at the lower of cost & NRV.

(a) Cost of inventories

The cost of inventories should include all costs incurred in bringing the inventory to its
present location & condition. This includes all:-
- costs of purchase,
- cost of conversion
- other costs incurred in bringing the inventories to their present location and
condition.

(b) Cost of purchase comprise of:-

- Purchase price less trade discounts or rebates, plus
- Import duties and other taxes, plus
- Transport, handling and any other cost directly attributable to the acquisition of
finished goods, services and materials.

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(c) Cost of conversion consists of:

- Direct production costs eg direct materials, direct labour; and
- Fixed and variable production overheads that are incurred in converting materials
into finished goods.

Fixed production overheads

- Fixed production overheads are indirect cost of production example depreciation

and maintenance of factory buildings, equipments used in the production process,
cost of factory management and administration which remain relatively constant
regardless of the volume of production.

- They are allocated to the cost of inventories based on normal level of activity.

- If the actual level of production approximates to normal capacity, use actual

production level.

- If actual production is lower than normal capacity, allocate based on normal

capacity. The unallocated overheads are expensed in the period in which they are
incurred.

- In times where the actual production is higher than normal capacity, the fixed
production overhead is allocated based on the actual production units. This is to
avoid inventories being measured at above cost.

Variable production overheads

Variable production overheads are allocated to each unit of production on the basis of
the actual production units.

(d) Other costs

Any other costs should only be recognized if they are incurred in bringing the
inventories to their present location and condition.

Cost excluded as inventory costs:

(i) abnormal amount of wastage (material, labour & overhead)

(ii) storage costs (except costs which are necessary in the production process before a
further production stage).

(iii) administrative overheads not incurred to bring inventories to their present location and
condition

(iv) selling costs.

(v) Borrowing costs except up to the extent permitted by IAS 23 Borrowing Costs.

These costs should be recognized as an expense in the period they are incurred.

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Example 1:

LCW Bhd. (LCW) buys sports equipments from various countries and exports them to
America. LCW has incurred the following expenses during 2016:-
1. Cost of purchase (based on suppliers’ invoices)
2. After-sales warranty costs
3. Trade discounts on purchases
4. Sales commission payable to sales agents
5. Import duties
6. Salaries of accounting department
7. Freight and insurance on purchases
8. Other handling costs relating to imports
9. Brokerage commission payable to agents to arrange imports.

Required: Which costs are permitted under IAS 2 to be included in cost of inventory?

Answer:

Items (1), (3), (5), (7), (8), and (9) are permitted to be included in cost of inventory under IAS
2. Salaries of accounting department, sales commission, and after-sales warranty costs are not
considered cost of inventory under IAS 2 and thus are not allowed to be included in cost of
inventory.

4. Cost formulas
A cost formula is required to determine the value of items in the inventories. The selection
of the correct cost formula depends upon the nature of the items.
(a) For inventory items that are not interchangeable & goods and services produced and
segregated for specific projects, specific costs are attributed to these individual items of
inventory. Such items should be shown at their actual individual costs.

Example:

For special made-to-order furniture, specific costs of material and labour used are
identified and included in the cost.

(b) For items which are interchangeable (identical or very similar), the cost of inventories
should be assigned by using either First-in, First-out (FIFO) or Weighted Average (WA)
cost formulas. Last-in, First out (LIFO) is not permitted by IAS 2.

FIFO – This method assumes that the item which came first into inventory (by way of
purchase or production) goes out first (as sales or consumption). This means that items
remaining in hand are those which were purchased the last.

This is an assumption for the purpose of determining the cost and the actual movement
of the goods may or may not be in that manner. However, generally, the storekeepers
ensure that the oldest items are removed out first.

Weighted Average – Total cost of material (opening inventory + subsequent purchases) is

divided by the total quantity (opening inventory + subsequent purchases). This is done
either after each purchase or alternatively only at the period end.

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Weighted average = Total cost of material

Total quantity of material

The same cost formula should be used for all inventories with similar characteristics as to
their nature and use to the entity. For groups of inventories that have different
characteristics, different cost formulas may be justified.

5. Net Realizable Value (NRV)

Net realizable value (NRV) 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.

RM
Estimated selling price X
Less: Estimated costs of completion (X)
Less: Estimated selling costs (X)
Net realizable value X

Under the prudence concept, assets SHOULD NOT be carried at amounts greater than
those expected to be realized from their sale/use.

For inventories, the NRV is likely to be less than cost in the following circumstances:-
- when the items are damaged;
- when the items are obsolete (no longer in use);
- when there is an increase in costs or a fall in selling price
- when the company’s marketing strategy is to manufacture and sell products at a
loss
- errors in production or purchasing
Slow moving inventory items often provide indications that there could be items which
require a write down to NRV.

NRVs are determined after considering:-

a) the most reliable estimates available
b) fluctuations after the end of the reporting period, to the extent that they confirm the
conditions existing on the end of the reporting period
c) The purpose for which the inventory is held. Eg, when inventories are held for the
purpose of satisfying a firm sales contract, the NRV is based on the contract price.

The comparison between cost and NRV is to be done item by item. However, similar or
related items (example, items in the same product line) may be grouped together. For
example, where items of inventory relate to the same product line, have similar purposes
and uses, and are produced and marketed in the same geographical area, the groups of
similar items basis may be more appropriate. Whichever basis is used, it should be applied
consistently. It is not acceptable to write down inventories based on a whole classification
(eg finished goods) or a whole business.

The NRV should be assessed at the same time the estimates are made for selling price,
using the most reliable information available. Fluctuations of price or cost should be taken
into account if they relate directly to events after the reporting period, which confirm
conditions existing at the end of the period.

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NRV must be reassessed at the end of each period and compared again with cost.
Any write-down to NRV should be recognized as an expense in the period in which the
write-down occurs. If the NRV has risen for inventories held over the end of more than
one period, then the previous write down must be reversed to the extent that the inventory
is then valued at the lower of cost and the new NRV. This may be the case when selling
prices have fallen in the past and then risen again. Any reversal should be recognized in
the SOPL in the period in which the reversal occurs.

On occasion, a write down to NRV may be of such size, incidence or nature that it must be
disclosed separately.

6. Recognition of expense

When inventories are sold, the following treatment is required:

(a) The carrying amount is expenses in the period in which the related revenue is
recognized.
(b) The amount of any write-down of inventories to NRV and all losses of inventories
are recognized as an expense in the period the write-down or loss occurs.
(c) The amount of any reversal of any write-down of inventories, arising from an
increase in NRV is recognized as a reduction in the amount of inventories
recognized as an expense in the period in which the reversal occurs.

7. Consistency in use of cost formulas

IAS 2 allows FIFO and WA to be used for inventories which are ordinarily
interchangeable or are not produced and segregated for specific projects.

IAS 2 provides that an entity should use the same cost formula for all inventories having
similar nature and use to the entity. For inventories with different nature or use (for
example, certain commodities used in one business segment and the same type of
commodities used in another business segment), different cost formulas may be justified.
A difference in geographical location of inventories by itself is not sufficient to justify the
use of different cost formulas.

8. Disclosures

The main disclosure requirements of IAS 2 are:

• accounting policy for inventories

• carrying amount, generally classified as merchandise, supplies, materials, work in
progress, and finished goods. The classifications depend on what is appropriate for
the entity
• carrying amount of any inventories carried at fair value less costs to sell
• amount of any write-down of inventories recognised as an expense in the period
• amount of any reversal of a write-down to NRV and the circumstances that led to
such reversal
• carrying amount of inventories pledged as security for liabilities
• cost of inventories recognised as expense (cost of goods sold).

Sources:
(1) Paper F7 Financial Reporting ACCA Study Text, BPP, 2014. Chapter 12
(2) FRS for Malaysia by Jane Lazar Chapter 9

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Additional practice questions

Q1.

XYZ Sdn Bhd (XYZ) carried out an inventory count on 4 January 2015. The count
showed a closing inventory value for the year ended 31 December 2014 at RM836,200.
Between 31 December 2014 and 4 January 2015, the following transactions took place:

RM
Purchases of goods 8,600
Sales of goods @ profit margin 30% on sales 14,000
Goods returned by XYZ to supplier 700

What inventory figure should be included in the financial statements of XYZ as at 31

December 2014?

Suggested answer:
RM
Inventory count @ 4/1/15 836,200
Less: Purchases (8,600)
Add: Sales 9,800
Add: Goods returned to supplier 700
838,100

Q2.

ABC Sdn Bhd (ABC) buys and restores items of exclusive vintage jewellery. At 31 May
2014, the company had three items in inventory. Details of the items were:

Necklace Bracelet Pendant

RM RM RM
Purchase cost 12,000 31,000 45,000
Expected selling price 25,000 38,000 53,000
Restoration costs to date 6,000 5,000 2,000
Further costs before sale 2,000 3,000 1,000

What was the value of ABC inventory as at 31 May 2014?

Suggested answer:

Inventory cost = Purchase cost + Restoration costs to date

NRV = Expected selling price – Further costs before sale

Necklace Bracelet Pendant Total

RM RM RM
Cost 18,000 36,000 47,000
NRV 23,000 35,000 52,000

Valuation @ 18,000 35,000 47,000 100,000