3 Statement of profit or loss

$m
Revenue (40% x $550) 220
Cost of sales (balancing figure) (235)
Loss (15)

4 Statement of financial position

$m
Costs incurred to date 225
Recognised loss (15)
Less receivables (290)
Contract liability (80)

4 Inventories and short-term WIP (IAS 2)

IAS 2 was revised in December 2003. It lays out the required accounting treatment
for inventories (sometimes called stocks).

The following items are excluded from the scope of the standard.

 Work in progress under construction contracts (covered by IFRS 15 Revenue

from contracts with customers, see Section 3)

 Financial instruments (ie shares, bonds)

 Biological assets

Certain inventories are exempt from the measurement rules, ie those held by:

 Producers of agricultural and forest products and minerals

 Commodity-broker traders

Definitions
These are the important definitions:

Inventories are assets:

 held for sale in the ordinary course of 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.
Net realisable value 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. (IAS 2)
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. (IFRS 13)

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Inventories can include any of the following.

 Goods purchased and held for resale, eg goods held for sale by a retailer, or
land and buildings held for resale

 Finished goods produced

 Work in progress being produced

 Materials and supplies awaiting use in the production process (raw materials)

The standard states that 'Inventories should be measured at the lower of cost and
net realisable value.'

Cost of inventories
The cost of inventories will consist of all costs of:

 Purchase
 Costs of conversion
 Other costs incurred in bringing the inventories to their present location and
condition
The standard lists the following as comprising the costs of purchase of inventories:

 Purchase price plus

 Import duties and other taxes plus
 Transport, handling and any other cost directly attributable to the acquisition
of finished goods, services and materials less
 Trade discounts, rebates and other similar amounts.
Costs of conversion of inventories consist of two main parts:

(a) Costs directly related to the units of production, eg direct materials, direct
labour.

(b) Fixed and variable production overheads that are incurred in converting
materials into finished goods, allocated on a systematic basis.

Fixed production overheads are those indirect costs of production that remain
Part B 7: Revenue and inventories

relatively constant regardless of the volume of production, eg the cost of factory

management and administration.
Variable production overheads are those indirect costs of production that vary
directly, or nearly directly, with the volume of production, eg indirect materials and
indirect labour. (IAS 2)

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 The standard emphasises that fixed production overheads must be allocated to items
of inventory on the basis of the normal capacity of the production facilities. This is
an important point.

(a) Normal capacity is the expected achievable production based on the average
over several periods/seasons, under normal circumstances.

(b) The above figure should take account of the capacity lost through planned
maintenance.

(c) If it approximates to the normal level of activity then the actual level of
production can be used.

(d) Low production or idle plant will not result in a higher fixed overhead
allocation to each unit.

(e) Unallocated overheads must be recognised as an expense in the period in

which they are incurred.

(f) When production is abnormally high, the fixed production overhead allocated
to each unit will be reduced, so avoiding inventories being stated at more
than cost.

(g) The allocation of variable production overheads to each unit is based on the
actual use of production facilities.

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

Certain types of cost would not be included in cost of inventories and should be
recognised as an expense in the period in which they are incurred.

(a) Abnormal amounts of wasted materials, labour or other production costs

(b) Storage costs (except costs which are necessary in the production process
before a further production stage)

(c) Administrative overheads not incurred to bring inventories to their present

location and condition

(d) Selling costs

Net realisable value (NRV)

As a general rule assets should not be carried at amounts greater than those
expected to be realised from their sale or use. In the case of inventories this amount
could fall below cost when items are damaged or become obsolete, or where the
costs to completion have increased in order to make the sale.

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In fact we can identify the principal situations in which NRV is likely to be less than
cost, ie where there has been:
(a) An increase in costs or a fall in selling price
(b) A physical deterioration in the condition of inventory
(c) Obsolescence of products
(d) A decision as part of the entity's marketing strategy to manufacture and sell
products at a loss
(e) Errors in production or purchasing
A write down of inventories would normally take place on an item by item basis, but
similar or related items may be grouped together. This grouping together is acceptable
for, say, items in the same product line, but it is not acceptable to write down
inventories based on a whole classification (eg finished goods) or a whole operating
segment.
The assessment of NRV should take place 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. Any write down to NRV should be recorded as an expense in profit
or loss in the period in which it occurs.
The reasons why inventory is held must also be taken into account. Some inventory,
for example, may be held to satisfy a firm contract and its NRV will therefore be the
contract price. Any additional inventory of the same type held at the period end will,
in contrast, be assessed according to general sales prices when NRV is estimated.
Net realisable value must be reassessed at the end of each period and compared
again with cost. 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 possible
when selling prices have fallen in the past and then risen again.
On occasion a write down to NRV may be of such size, incidence or nature that it
must be disclosed separately.

Cost formulae for inventories

Part B 7: Revenue and inventories

IAS 2 allows two cost formulae (FIFO or weighted average cost) for inventories that
are ordinarily interchangeable or are not produced and segregated for specific
projects. The issue is whether an entity may use different cost formulae for different
types of inventories.
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 operating segment and the same
type of commodities used in another operating segment), different cost formulae may

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 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 cost formulae.

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