Inventories

What are inventories?

Inventories are assets: held for sale in the ordinary course of business; in the process of
production for sale; or in the form of materials or supplies to be consumed in production
or in rendering services [IAS2R.6].

The inventory of manufacturing entities is raw materials and consumable stores; work in
progress and finished goods, awaiting sale. Agricultural entities hold as inventory
agricultural produce harvested from biological assets [IAS2R.20]. Goods purchased and
held for resale with little or no conversion are typical of retail inventories [IAS2R.8].
Real estate purchased for resale should be recognised as inventory . Conversely, property
held for use in a production process, for rental to others or for administrative purposes,
should be recognised as property, plant and equipment [IAS16R.6].
The cost of services rendered by a service entity may, in rare circumstances, be
recognised as inventories, where the entity has not recognised the related revenues. This
amount should however be minimal, given the requirement to recognise service revenues
on the percentage-of-completion basis.

Inventories do not include work in progress arising from completion of a construction

contract. This is recognised in accordance with IFRS requirements for construction
contract accounting .

The standard does not apply to financial instruments and biological assets related to
agricultural activity and agricultural produce at the point of harvest.

Inventories outside the scope of IAS 2

IAS 2 does not apply to the measurement of the inventories held by [IAS2R.3]:

a) Producers of agricultural and forest products, agricultural produce after harvest, and
mineral and mineral products, if they are measured at net realisable value in accordance
with industry practices; or

b) Commodity broker-traders who measuring their inventories at fair value less costs to
sell.

Initial recognition
The primary issue in accounting for inventories is the amount of cost to be recognised as
an asset and carried forward until revenue is recognised.
An entity should initially recognise inventory when it has control of the inventory,
expects it to provide future economic benefits [F.49(a)] and the cost of the inventory can
be measured reliably [F.89]. Initial recognition of inventory is straightforward. Entities
recognise inventories when they expect to generate benefits from their use, or eventual
sale to customers.
Initial measurement
Initial measurement of inventories is at cost [F.100(a)]. The cost of inventories includes:
the cost of all materials that enter directly into production and the costs of converting
those materials into finished goods. The direct materials costs include, in addition to the
purchase price, all other costs necessary to bring them to their existing condition and
location [IAS2R.10].
The cost of raw materials, consumables and land and buildings purchased for resale is the
purchase price including transportation charges, import duties, insurance, warehousing
and handling costs, reductions made for trade discounts, rebates and other similar items
[IAS2R.11] .

Agricultural produce, such as wool, logs and grapes is the harvested product of biological
assets and is recognised as inventory [IAS2R.20]. The cost of agricultural produce at
initial recognition is its fair value less estimated point-of-sale costs at the point of harvest
[IAS41.13].

Investment property is reclassified as inventory when an entity proposes to develop the

property for sale [IAS40R.57(b)] . The property's cost at initial recognition would be its
cost less accumulated depreciation [IAS40R.59] or fair value at the date of transfer
[IAS40R.60], depending on the measurement alternative the entity previously adopted in
accounting for the property as investment property.

Measurement subsequent to initial recognition

Subsequent to initial recognition, entities should measure inventories at the lower of cost
or net realisable value [IAS2R.9].
Cost should be determined based on specific identification for goods not ordinarily
interchangeable or those segregated for specific projects [IAS2R.23]. Specific
identification costing is not appropriate for inventories of homogeneous products, such as
raw materials to be used in production and spare parts that have often been purchased at
different prices [IAS2R.24]. Weighted average or FIFO (the benchmark treatment)
[IAS2R.25] may be used to determine the cost of such inventory.

There are a number of methodologies for inventory costing, which fall within the
categories of weighted average and FIFO. Many methods are specific to an entity or
industry and some are complex . IFRS describe methods of application only very
generally, and any method that produces a result consistent with the principles in the
standard is acceptable. Whatever application method an entity uses, it should apply that
method consistently [IAS2R.25,26] .

Conversion costs
Entities engaged in manufacturing goods must assign costs to inventory. The costs of
inventories should include all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition [IAS2R.10] .
IFRS do not permit direct costing methods, where all overheads are expensed. Such costs
are allocated to inventory, regardless of their classification by the entity [IAS2R.13].

Fixed production overheads are recognised as part of the cost of inventories based on
normal capacity . Normal capacity is that level of production that an entity expects to
achieve on average over several periods [IAS2R.13]. Variable production overhead costs
are recognised for each unit produced, on the basis of actual production [IAS2R.13]. An
entity must charge unallocated overheads, such as idle capacity variances to the cost of
sales in the current period [IAS2R.13] .

Capitalisation of storage costs is appropriate only if the storage is necessary in the

production process prior to a further production stage [IAS2R.16(b)] .

Joint products and by products

Products that are produced together are known as joint products or common products.
The costs of these products incurred after the point at which the individual products
become identifiable (often called separable or added costs) can easily be identified with
the product. The entity however must allocate costs before that point to individual
products by a reasonable method [IAS2R.14].

The allocation of costs based on the relative sales value of the joint products is one
method of allocating joint costs. Joint costs are allocated based on the relative sales value
of the products at the point of separation [IAS2R.14]. This method is practical when joint
products are equally profitable, but inappropriate where products have significantly
different profit margins, as the allocation does not reflect the costs.

By-products are joint products of relatively insignificant value. Accounting for them as
joint products is not appropriate. An appropriate alternative is to assign costs to by-
products equal to their net sales value by deducting their net sales value from the main
product [IAS2R.14].

Inventories of a service provider

Inventories of service providers are costs incurred in providing the services, for which the
entity has not recognised revenues. These costs consist of labour and related employment
costs of employees directly engaged in providing the service, including supervisory
personnel [IAS2R.19]. All indirect costs (overheads) associated with providing the
service, such as the cost of facilities, transportation, training, supplies etc., should also be
recognised as part of the cost of service inventories. Labour and associated costs relating
to sales and general administrative personnel should not be included in inventory, but
recognised as expense in the period incurred [IAS2R.19].

Revenues from the rendering of services should be recognised under the percentage-of-
completion method [IAS18.20]. Revenues are recognised in the period to the extent that
services are rendered [IAS18.21]. Accordingly, the costs of those services are also
charged to expense in that period. The balance sheets of service providers reflect
relatively minor amounts of inventories.

Derecognition
Inventory is derecognised when it is sold. An entity should also derecognise inventory
when it has no future economic value, for example obsolete inventory [F.83(a)].
The point at which to derecognise inventory is not always straightforward. For example,
where an entity supplies goods to a dealer on consignment [IAS18.Appendix.2(c)] or
under sale and repurchase agreements [IAS18.Appendix.5], the entity may retain the risks
and rewards of ownership and should continue to recognise the asset [IAS18.13] .

Impairment
The requirements to measure inventory at the lower of cost and NRV [IAS2R.9] forces
the recognition of impairment losses as they occur. Write-downs to NRV may be
triggered where selling prices have declined or costs of completion or direct selling costs
have increased. Some products may have become damaged or some may be held in
quantities that will not be sold in a reasonable period [IAS2R.28]. In these circumstances
the inventories should be written down below cost to expected recoverable amounts.

The amount of the impairment should be determined on an item-by-item basis. Such an

assessment may not be practical, in which case impairment is measured for a group of
similar or related items. Items are similar or related if they are from the same product
line, have similar purposes or end uses and are produced and marketed in the same
geographical segment. The write-down should take into account the estimated completion
and disposal costs but should not include a profit margin arising in the future production
stages [IAS2R.28-33] .

The market prices of materials and supplies held for use in manufacturing may decline
below cost. The entity should however continue to recognise the materials at cost if it
expects to sell the finished products at prices above cost. [IAS2R.32] .

NRV should be determined based on the conditions that existed at the balance sheet date.
Events after the end of the period should be considered to the extent that they confirm
conditions existing at or before the balance sheet date [IAS2R.30]. This evaluation calls
for the exercise of judgement. All available data should be considered including
subsequent changes in selling prices or costs [IAS2R.30] .

IFRS require that a write-down to NRV taken in a prior period be reinstated when the
conditions causing the write-down cease to exist [IAS2R.33].
Use of financial instruments on the measurement of inventories

Purchase of inventories
Commodity price and foreign exchange price movements between the date of order and
settlement may expose an entity to risks when purchasing inventories. Commodity price
risk arises where an entity purchases a commodity that is subject to price fluctuation, and
a foreign exchange risk arises where the entity pays for the inventory in a foreign
currency.
a) Managing commodity price risk
To mitigate or hedge the price risk, the entity may enter into a fixed price forward
contract to buy the commodity at a fixed price at a future date.

The entity does not separately recognise the forward contract (as a derivative) where it
takes physical delivery of the inventory and for which there is no practice of settling net
(either with the counterparty or by entering into offsetting contracts [IAS39R.5-7]
[IAS39IG.A1].

Alternatively, the entity may settle the contract prior to taking delivery of the commodity.
The forward contract is recognised as a derivative in this case . The derivative may
qualify as a hedging instrument. Any changes in fair value would be initially deferred in
equity if it is designated as a cash flow hedge of a highly probable forecasted future
transaction. The amount deferred in equity is included as part of the cost of inventory on
initial recognition [IAS39R.97,98].

b) Managing foreign exchange risk

An entity may enter into a contract to purchase inventory in a currency other than that of
the entity's reporting currency. In effect the contract is: a host contract to purchase
inventory and a swap or forward contract to exchange one currency for another (an
embedded derivative).

The entity should not separately recognise the derivative if the currency for the forward
purchase is the supplier's measurement currency [IAS39R.AG33]. A forward purchase
contract denominated in a third currency, that is, not the measurement currency of the
supplier or the purchaser, would be regarded as a host contract with an embedded foreign
currency derivative unless the third currency is one in which the contract prices are
routinely quoted in international commerce [IAS39R.AG33]. The embedded derivative
should be recognised separately from the host contract in accordance with the
requirements of accounting for derivatives [IAS39R.11]. The remaining host contract will
be a forward purchase contract in the entity's own currency .

Presentation and disclosure

Inventories should be presented as a line item on the face of the balance sheet
[IAS1R.68(g)].
Classification of inventory (in the balance sheet or notes) should be in a manner
appropriate to the entity [IAS1R.74]. The amounts for each classification should be
shown. Classification chosen should be applied consistently [IAS1R.27]. The most
common classifications are supplies, raw materials, work-in-progress and finished goods
( [IAS2R.36(b)][IAS2R.37].

The following disclosures are required [IAS2R.36(a)-(h)]:

a) accounting policies adopted including cost formula used;

b) carrying amount of inventories and carrying amount in classifications appropriate to

the entity;

c) carrying amount of inventories carried at fair value less costs to sell ;

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

e) the amount of any write-down of inventories;

f) the amount reversed of a previous write-down recognised as income in the period;

g) the circumstances that led to the reversal of a previous write-down; and

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