ISM 502 Accounting Standards Application

Notes for Week 5

IAS 2 Inventories

IAS 2 Inventories is an International Financial Reporting Standard (IFRS), which regulates the
accounting treatment of inventories. This standard applies to all inventories, except financial
instruments and agricultural products before they are harvested. All finished products that are
produced or bought, work in progress goods, raw materials and supplies needed for production or
rendering a service are considered inventories by this standard.

Net realizable value is the selling price, where the costs of completion and costs related to make the
sale are deducted. Fair value is the sales price, which is negotiated between the related parties.

The Value of Inventories

According to the Standard, the value of an inventory should be the lower of cost and net realizable
value (AIS 2: 9). Therefore, an inventory should be recorded with its acquisition (cost) value or with
the selling price, where the costs of completion and costs related to make the sale are deducted (net
realizable value), whichever one is lower.

Cost of Inventories

The fundamental characteristics that comprise the cost of an inventory are as follows:

 Purchasing costs are included. These costs are related to the acquisition of finished goods,
materials and services. The following costs are included in the purchasing cost:
o The purchase price
o Import duties
o Other taxes, except the ones which are recoverable from the taxing authorities
o Transportation costs
o Handling costs
o Other costs related to the acquisition of the inventory.
o Discounts and rebates are deducted from the purchasing costs.
 Costs of conversion is included. These costs are related to production. Following principles
are valid when calculating the costs of conversion:
o Direct costs of production, e.g. direct labor, are included.
o Allocated portion of the general production expenses to the finished goods inventory
is included. These are indirect costs. Some examples of these costs are as follows:
indirect materials, indirect labor, general production expenses like depreciation of
assets related to production site, maintenance of factory buildings, cost of factory
management and administration.

The following costs are not included into the cost of an inventory:

 The costs related to wasted amounts: Costs due to the abnormal usage of materials, labor or
other production costs are not included in the cost of the inventory.
 Storage costs: Costs related to storing the inventory should not be included. However, the
storage costs necessary for the production process, such as storing materials or work in
progress goods before a production stage, are included in the cost of the inventory.

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  Administrative costs: If an administrative cost, which is not related to bringing inventories to
their present location and condition, should not be included into the cost of the inventory.
 Sales costs: Costs related to the sale of the inventory are not included into the cost of the
inventory.
 Financial costs:
o If an inventory is purchased on credit, the difference between the purchasing price
and the amount that is paid is considered an interest expense. This amount is not
included in the cost of the inventory.

Assigning Costs to Inventories

The identifiable costs related to an inventory or a project are assigned to that inventory. For this to
happen the product or service has to have unique features and the costs can be attributed as the
costs the inventory in question. This treatment of costs are valid for both bought and produced
inventories.

It is not likely to assign costs to inventory when the inventory consists of large number of
interchangeable items. The costs need to be calculated for this type of inventory. Two methods are
allowed by the Standard, namely the first-in first-out (FIFO) method and weighted average method.
The entity has to choose one of these methods and has to be consistent within the accounting year
and the years to come for the comparability of its financial statements.

Recognition as an Expense

When an inventory is sold, its value is deducted from inventories and it becomes an expense of the
period.

Accounting Applications

1. ABC Corporation buys trade goods with a list price of TL 10,000 (18% VAT not included). The value
added tax (VAT) of the merchandise is TL 1,800. The goods are sent by cargo for TL 200, and insured
for TL 100. The shipment costs are paid by the company. The company rents a storage room to put
the merchandise, and pays TL 500 until the end of the current accounting year. The general
administrative expenses for the period that the merchandise is owned by the company is TL 5,000.

The cost of the inventory is calculated as follows:

List price TL 10,000

Transportation cost TL 300 (cargo TL 200 + insurance TL 100)

Total cost TL 10,300

The rent and the administrative expenses are not related to the acquisition of the inventory.
Therefore, they are not included in the cost. The value added tax on the merchandise will be
deducted eventually. Hence, it is not included in the cost as well.

2. ABC Corporation buys trade goods on credit. Their list price is TL 20,000 (18% VAT not included).
However, the company will pay TL 21,000 three months after the purchase.

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As it is seen, the company is paying TL 1,000 extra for the three months between the purchase and
the payment. This TL 1,000 is considered a borrowing cost, and is not included to the cost of the
inventory.