PAS 2 - Inventories

PPT

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CONTENTS:
1. Introduction
2. Exemptions
3. Inventories
4. Measurement
5. Cost
6. Cost Formulas
7. Net Realizable Value (NRV)
8. Recognition as an Expense
9. Disclosures

Introduction Precious
PAS 2 prescribes the accounting treatment for inventories.
PAS 2 recognizes that a primary issue in the accounting for inventories is the determination of
cost to be recognized as asset and carried forward until it is expensed.
PAS 2 provides guidance in the determination of cost of inventories, including the use of cost
formulas, and their subsequent measurement and recognition as expense.

Exemptions Precious
PAS 2 applies to all inventories except for the following:
Assets accounted for under other standards
● Financial instruments (PAS 32 and PFRS 9)
● Biological Assets and agricultural produce at the point of harvest. (PAS 41)

Assets not measured under the lower cost or net realizable value (NRV) under PAS 2
● Inventories of producers of agricultural, forest, and mineral products measured at net
realizable value in accordance with well-established practices in those industries.
● Inventories of commodity broker-traders measured at fair value less costs to sell.

INVENTORIES Hanah
Inventories are as assets:
a. Held for sale in the ordinary course of business (finished goods);
b. In the process of production such sale ( work in process)
c. In the form of materials or supplies to be consumed in the production process or in the
rendering of services (raw materials and manufacturing supplies).
Examples:
1. Merchandise purchased by a trading entity and held for resale.
2. Land and other property held for sale in the ordinary course of business.
3. Finished goods, goods undergoing production, and raw materials and supplies awaiting
use in the production process by a manufacturing entity.

Ordinary course of business refers to the necessary, normal or usual business activities of an
entity.

Measurement Hanah
Inventories are measured at the lower of cost and net realizable value.

Cost Sam
The cost of inventories comprises the following:
a. Purchase cost - this includes the purchase price (net of trade discounts and other rebates),
import duties, non-refundable or non-recoverable purchase taxes, and transport, handling and
other costs directly attributable to the acquisition of the inventory.

b. Conversion costs - these refer to the costs necessary in converting raw materials into
finished goods. Conversion costs include the costs of direct labor and production overhead.

c. Other costs necessary in bringing the inventories to their present location and condition.

Certain costs are excluded from inventory costs and must be expensed in the period incurred:

● Abnormal waste (such as excess materials or inefficient labor).

● Storage costs (unless they are necessary before further production stages).
● Administrative overheads that don’t contribute to the inventory's production.
● Selling costs, such as advertising or freight out.

When a purchase transaction effectively contains a financing element, such as when

payment of the purchase price is deferred, the difference between the purchase price for normal
credit terms and the amount paid is recognized as interest expense over the period of the
financing.
Illustration:
Entity A acquires inventories and incurs the following costs:

Purchase price, gross of trade discount 100,000

Trade discount 20,000
Non-refundable purchase tax, not included
in the purchase price above 5,000
Freight-in (Transportation costs) 15,000
Commission to broker 2,000
Advertisement costs 10,000

Requirement: How much is the cost of the inventories purchased?

Solution:

Purchase price, gross of trade discount 100,000

Trade discount (20,000)
Non-refundable purchase tax, not included 5,000
in the purchase price above
Freight-in (Transportation costs) 15,000
Commission to broker 2,000
Total cost of inventories 102,000

The advertisement costs are selling costs. These are expensed in the period in which they are
incurred.

Cost Formulas Sam

PAS 2 provides the following cost formulas:
1. Specific identification - this shall be used for inventories that are not ordinarily
interchangeable (i.e., those that are individually unique) and those that are segregated for
specific projects.

2. First-In, First-Out (FIFO) - Under this formula, it is assumed that inventories that were
purchased or produced first are sold first, and therefore unsold inventories at the end of the
period are those most recently purchased or produced.

Accordingly, cost of sales represents costs from earlier purchases, while the cost of ending
inventory represents costs from the most recent purchases.

3. Weighted Average - Under this formula, cost of sales and ending inventory are determined
based on the weighted average cost of beginning inventory and all inventories purchased or
produced during the period. The average may be calculated on a periodic basis, or as each
additional purchase is made, depending upon the circumstances of the entity.

Net realizable value (NRV) HANAH AND PRECIOUS

Net realizable 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." (PAS 2.6)
NRV is different from fair value. "Net realizable value refers to the net amount that an
entity expects to realize from the sale of inventory in the ordinary course of business. Fair value
reflects the price at which an orderly transaction to sell the same inventory in the principal (or
most advantageous) market for that inventory would take place between market participants at
the measurement date. The former is an entity-specific value; the latter is not. Net realizable
value for inventories may not equal fair value less costs to sell." (PAS 2.7)
Measuring inventories at the lower of cost and NRV is in line with the basic accounting
concept that an asset shall not be carried at an amount that exceeds its recoverable amount.
The cost of an inventory may exceed its recoverable amount if, for example, the
inventory is damaged, becomes obsolete, prices have declined, or the estimated costs to
complete or to sell the inventory have increased. In these circumstances, the cost of the
inventory is written-down to NRV. The amount of write-down is recognized as expense.
If the NRV subsequently increases, the previous write-down is reversed. However, the
amount of reversal shall not exceed the original write-down. This is so that the new carrying
amount is the lower of the cost and the revised NRV.
Write-downs of inventories are usually carried out on an item by item basis, although in
some circumstances, it may be appropriate to group similar items. It is not appropriate to write
down inventories on the basis of their classification (e.g, finished goods or all inventories of an
operating segment).
Raw materials inventory is not written down below cost if the finished goods in which
they will be incorporated are expected to be sold at or above cost. If, however, this is not the
case, the raw materials are written down to their NRV. The best evidence of NRV for raw
materials is replacement cost.

Illustration:
Information on Entity A's inventories is as follows:

Product A Product B
Cost 100,000 200,000
Estimated selling price 140,000 220,000
Estimated costs to sell 20,000 30,000

Requirement: Compute for the valuation of Products A and B in Entity A's statement of financial
position.

Solution:
Estimated selling price Product A
Cost Estimated costs to sell 100,000
140,000 Product B 220,000
(20,000) 200,000 (30,000)
Net realizable value 120,000 190,000

Lower 100,000 190,000

Amount of write-down - 10,000

Analysis:
• Product A need not be written-down because its cost is lower than its NRV.
• Product B shall be written-down by P10,000 because its cost exceeds its NRV
(200,000 cost less 190,000 NRV).
• The total inventory to be shown in the statement of financial position is P290,000
(100,000 for Product A + 190,000 for Product B).
• The P10,000 write-down is recognized as expense in profit or loss.

Recognition as an expense Mark

The carrying amount of an inventory that is sold is charged as expense (i.e., cost of sales) in the
period in which the related revenue is recognized. Likewise, the write-down of inventories to
NRV and all losses of inventories are recognized as expense in the period the write-down or
loss occurs.
"The amount of any reversal of any write-down of inventories, arising from an increase in
net realizable value, shall be recognized as a reduction in the amount of inventories recognized
as an expense in the period in which the reversal occurs." (PAS 2.34)
Inventories that are used in the construction of another asset is not expensed but rather
capitalized as cost of the constructed asset. For example, some inventories may be used in
constructing a building. The cost of those inventories is capitalized as the cost of the building
and will be included in the depreciation of that building.

Disclosures Mark
a. Accounting policies adopted in measuring inventories, including the cost formula used;
b. Total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity;
c. Carrying amount of inventories carried at fair value less costs to sell;
d. Amount of inventories recognized as an expense during the period;
e. Amount of any write-down of inventories recognized as an expense in the period;
f. Amount of any reversal of write-down that is recognized as a reduction in the amount of
inventories recognized as expense in the period;
g. Circumstances or events that led to the reversal of a write down of inventories; and
h. Carrying amount of inventories are pledged as security for liabilities. (PAS 2.36)