IAS 2 - ACCOUNTING FOR INVENTORIES

INVENTORIES

Inventories are items or goods in stocks principally intended for sale to customers. In a layman's terms, these are the goods being sold in a marketplace, malls, groceries, supermarts, convenience stores, and others alike.

(source: from Google image search)

But what really is the exact definition of inventory? In this blog, I would like to introduce to you the International Accounting Standard No. 2 (IAS 2) which covers the accounting for inventories. IAS 2 contains the requirements on how to account for most types of inventory - whether it is raw material, work in process, finished goods, or merchandise goods.

For a more comprehensive discussion of inventory, you may also check the following applicable accounting standards:

FOR LARGE/ LISTED ENTITIES	FOR SMALL & MEDUIM-SIZED ENTITIES	FOR MICRO-ENTITIES
PAS 2 – Inventories	Section 13 (PFRS for SMEs) – Inventories	Section 8 (PFRS for SEs) – Inventories
PAS 41 – Agriculture	Section 27.2 (PFRS for SMEs) – Impairment of Inventories	Section 21.361 (PFRS for SEs) – Impairment of Inventories
PFRS 5 – Non-current Assets Held for Sale and Discontinued Operations	Section 34 (PFRS for SMEs) – Specialized Activities: Agricultural Activity	Section 27.462 (PFRS for SEs) – Biological Assets: Agricultural Produce
PFRS 15 – Revenue from Contracts with Customers (for consignment stock and sale & repurchase agreements)		Published accompanying guidance for micro-entities while using IFRS for SMEs (G13)
IFRS for Crypto-assets

DEFINITION OF INVENTORY (IAS 2)

Inventories as per IAS 2 describe it as assets held for sale in the ordinary course of the business, in the process of production for such sale or in the form of materials or supplies to be consumed in the production process or in the rendering of services. [see PAS 2 paragraph 6]

Therefore, inventories include the following:

• Assets held for sale in the ordinary course of the business (finished goods)
• Assets in the production process for sale in the ordinary course of the business (work-in-process)
• Materials and supplies that are consumed in production (raw materials)
• Purchased subcomponents
• Goods held by a trader for resale (merchandise inventory)

CLASSIFICATION OF INVENTORY

The following are classifications of inventory depending on its form and nature how it was obtained.

I.                     Merchandising – goods purchased by a trading company for resale in the enterprise’s ordinary course of business.

II.                   Manufacturing – goods processed from raw materials and turned into finished goods for ultimate consumption of consumers.

a.       Raw materials – tangible goods purchased for direct use in the manufacture of goods for sale

b.       Work in process – manufactured items requiring further processing

c.       Finished goods – manufactured goods completed and ready for sale

d.       Manufacturing supplies – items purchased for indirect use in the manufacture of goods for resale

III.                 Service provider – the cost of the services of a service provider may be classified as a “work in process inventory” if not completely rendered/ when service is not completely done.

MEASUREMENT OF INVENTORY

As per IAS 2, there are two points to consider when measuring inventories:

•            Initial Recognition
•            Subsequent Recognition

Initial Measurement of Inventories – inventories are initially measured at HISTORICAL COST. The cost 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. [see PAS 2 paragraph 11]

a. Cost of Purchase

•            Purchase price
•            Import duties and non-refundable taxes
•            Handling costs
•            Transportation costs
•            Other directly attributable costs
•            Deductibles: trade discounts and other similar items

b. Cost of Conversion

•            Direct labor costs
•            Production overhead costs

c. Other costs

•            Borrowing costs
•            Storage costs incurred during maturation process or curing process
•            Non-production overhead costs (for specific customers)

d. Cost of agricultural produce harvested from biological assets

•             Fair value of the produce less estimated point of sale cost at the point of harvest

e. Cost of inventories of a service provider

•             Cost of personnel directly engaged in providing the service
•             Supervisory personnel costs directly engaged in providing the service
•             Directly attributable overhead cost
•             Exclusions: profit margins or non-attributable overheads

Subsequent Measurement of Inventories – inventories are subsequently measured at the LOWER of cost or net realizable value (LCNRV).

• Net Realizable Value – is the estimated selling price in the ordinary course of the business less the estimated costs of completion and the estimated costs necessary to make the sale.

• 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. 

The cost of inventories may not be recoverable under the following circumstances:

a. The inventories are damaged

b. The inventories have become wholly or partially obsolete

c. The selling prices have declined

d. The estimated cost of completion or the estimated cost of disposal has increased

NOTE: Inventories are usually written down to net realizable value on an item by item or

individual basis.

SUBSEQUENT MEASUREMENT	RESULTED TO	SHOULD BE RECORDED AS
if COST > NRV = choose NRV	Inventory Write-down	Added to Cost of Sales
If COST < NRV = choose COST	Write-down REVERSAL if inventory was previously recorded at NRV	Deducted to Cost of Sales

EXCLUDED FROM INVENTORIES UNDER PAS 2 / IAS 2

Please take note that the following cost are not included in the cost of inventories:

a. Abnormal amounts of wasted materials, labor, or other production costs

b. Storage costs, unless these costs are necessary in the production process prior to a further production stage

c. Administrative overheads that do not contribute to bringing inventories to their present location and condition; and

d. Distribution or selling costs

INVENTORY RECORDING METHODS

Inventories may be accounted using two methods – PERIODIC and PERPETUAL inventory

methods

1. Periodic Inventory System – is a method of accounting inventory that requires physical inventory count at the end of the reporting year. All purchases are booked under “Purchases” account.

2. Perpetual Inventory System – is a method of accounting inventory that automatically updates the inventory balance from time-to-time when every time there is a purchase or sale. All purchases are directly booked to “Inventory” account while in every sale there is a corresponding “Cost of Sales” entry.

INVENTORY COST FLOWS (COST FORMULAS)

For inventories that are NOT INTERCHANGEABLE

a. Specific Identification

For inventories that are INTERCHANGEABLE

a. First-in, First-out (FIFO)

b. Weighted Average

The cost of inventory that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned using specific identification of their individual costs. The cost of inventories that are ordinarily interchangeable shall be assigned by using FIFO or weighted average method.

An entity shall use the same cost formula for all inventories having a similar nature and use. For inventories with a different nature or use, different cost formulas may be adjusted.

TECHNIQUES FOR THE MEASUREMENT OF INVENTORY COSTS

For convenience purposes, the Retail Method or Standard Cost Method may be used for approximate cost. Standard costs take into account normal levels of materials and supplies, labor efficiency and capacity utilization, but a regular review is a requirement and if necessary, revised in the light of current conditions. 

The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods. The cost of inventory is determined by reducing the sales value of the inventory by the appropriate percentage of gross margin.

INVENTORY ESTIMATION

Estimating inventory is a technique closely similar to techniques of measuring inventory costs (as discussed above). However, we use inventory estimation if:

 The inventory is destroyed by fire and other catastrophe, or theft of the merchandise has occurred and the amount of inventory is required for insurance purposes;

 A physical count of the goods on hand is made and it is necessary to prove the correctness or reasonableness of such count by making an estimate;

 Interim financial statements are prepared and a physical count of the goods on hand is not necessary either because it may take time to do the same or because only an estimate thereof is required to fairly present the financial position and performance of the entity.

There are two approaches in Estimating the Value of Inventory

1. Gross Profit Method

2. Retail Inventory Method

ACCOUNTING FOR INVENTORY WRITE-DOWN AND REVERSALS

If the cost is lower than the net realizable value, there is no accounting problem because the inventory is stated at cost and the increase is not recognized.

If the net realizable value is lower than cost, the inventory is measured at net realizable value. In this case, the problem is the proper treatment of the write-down of the inventory to its net realizable value. The write-down of inventory to net realizable value is accounted for using the “allowance method.”

Any write-down to NRV should be recognized as an expense (included as part of Cost of Sales) in the period in which the write-down occurs. Any reversal should be recognized in the income statement (as a deduction from Cost of Sales) in the period in which the reversal occurs.

SPECIAL INVENTORY TOPICS 

REPURCHASE AGREEMENTS

A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component. [see PFRS 15 B.64]

 

Repurchase agreements generally come in three forms:

• An entity’s obligation to repurchase the asset (a forward contract);
• An entity’s right to repurchase the asset (a call option);
• An entity’s obligation to repurchase the asset at the customer’s request (a put option).

If the repurchase agreement is a financing arrangement, the entity shall continue to recognize the “asset” and also recognize a “financial liability” for any consideration received from the customer. The entity shall recognize the difference between the amount of consideration received from the customer and the amount of consideration to be paid to the customer as “interest” and, if applicable, as processing or holding costs (for example, insurance).

If the option lapses and still unexercised, an entity shall derecognize the liability and recognize “revenue.”

 

CONSIGNMENT AGREEMENTS

A product that has been delivered to another party (e.g. consignee) may be held in a consignment agreement if that other party has not obtained control of the product.

Indicators that an arrangement is a consignment arrangement include, but are not limited to the following:

• The product is controlled by the entity until a specified event occurs, such as sale of the product to a customer of the dealer or until a specified period expires;
• The entity is able to require the return of the product or transfer the product to a third party (such as another dealer); and
• The dealer does not have an unconditional obligation to pay for the product (although it might be required to pay a deposit).

Accordingly, the consignor shall not recognize revenue upon delivery of a product to the consignee. In other words, the consignor shall recognize when:

i.                     The consignee sold the product to a customer; or

ii.                   After an expiration of a specified period.

 

PURCHASE COMMITMENTS

A purchase commitment is a non-cancellable agreement to purchase goods sometime in the future at a fixed price and fixed quantity.

When there is a reasonable certainty that inventories purchased under purchase commitment becomes impaired, “loss on purchase” commitment should be recognized in the period such impairment has been determined. Any “recovery” may be recognized as gain but such gain to be recognized should be limited to the loss recognized previously.

BONUS ACCOUNTING TIPS

You may consider the following tips to help you enlighten on some accounting problems.

ITEMS TO BE INCLUDED IN THE INVENTORY
1.       Goods in transit from supplier	Whose inventory is it?
a.       FOB Shipping point	Buyer
b.       FOB Destination	Seller
2.       Consigned goods	Consignor (seller)
3.       Sales out on approval	Seller
4.       Sales with buyback agreement	Seller
5.       Sales with product financing agreement	Seller
6.       Sales with right of return	Buyer
7.       Sales on installments	Buyer
8.       Segregated goods in the warehouse
a.       If mere segregation of goods only	Seller
b.       If “special order” goods	Buyer upon completion
c.       If “hold for shipping instructions”	Seller
9.       Park Sale	Seller

 

IDENTIFYING THE NET REALIZABLE VALUE OF AN INVENTORY
Raw Materials/ Factory Supplies	è Replacement Cost
Work in process Inventory	è Estimated selling price less estimated selling cost of completion less estimated cost to sell
Finished Goods Inventory	è Estimated selling price less estimated cost to sell

 

CONSIGNED GOODS: WHEN TO INCLUDE IN THE INVENTORY?
Terms used	The entity who said is acting as a…	Part of the entity’s Inventory?
Goods out for consignment	CONSIGNOR	YES
Goods held for consignment	CONSIGNOR	YES
Goods held on consignment	CONSIGNEE	NO
Goods on consignment	CONSIGNOR	YES
Consigned goods in transit	CONSIGNOR	YES
Inventories on consignment	CONSIGNOR	YES
Products held on consignment	CONSIGNEE	NO