IAS 2 INVENTORY

The following terms are used in this Standard with

the meanings specified:

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.

8-1
 IAS 2 INVENTORY
 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.

 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.

8-2
 Net realizable value
 Net realisable value refers to the net amount
that an entity expects to realise 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.
8-3
 Net realizable value
 The amount of any write‑down of inventories to
net realisable value and all losses of inventories
shall be recognised as an 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 realisable value,
shall be recognised as a reduction in the amount
of inventories recognised as an expense in the
period in which the reversal occurs.

8-4
  Inventories encompass goods purchased and
held for resale including, for example,
merchandise purchased by a retailer and held
for resale, or land and other property held for
resale. Inventories also encompass finished
goods produced, or work in progress being
produced, by the entity and include materials
and supplies awaiting use in the production
process.

8-5
 Measurement of inventories
 Inventories shall be measured at the lower of
cost and net realisable value.

8-6
 Cost of inventories
 The cost of inventories shall comprise all costs
of purchase, costs of conversion and other costs
incurred in bringing the inventories to their
present location and condition.

8-7
 Measurement of inventories
 The costs of purchase of inventories comprise
the purchase price, import duties and other
taxes (other than those subsequently
recoverable by the entity from the taxing
authorities), and transport, handling and other
costs directly attributable to the acquisition of
finished goods, materials and services. Trade
discounts, rebates and other similar items are
deducted in determining the costs of purchase.

8-8
 Cost of Conversion

 The costs of conversion of inventories include costs

directly related to the units of production, such as
direct labour. They also include a systematic
allocation of fixed and variable production overheads
that are incurred in converting materials into finished
goods.

8-9
 Cost of Conversion

 Fixed production overheads are those indirect costs

of production that remain relatively constant
regardless of the volume of production, such as
depreciation and maintenance of factory buildings
and equipment, and 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, such as indirect materials and indirect
labour.

8-10
 Other costs

 Other costs are included in the cost of inventories

only to the extent that they are incurred in bringing
the inventories to their present location and
condition. For example, it may be appropriate to
include non‑production overheads or the costs of
designing products for specific customers in the cost
of inventories.

8-11
 Costs excluded

 Costs excluded from the cost of inventories and

recognised as expenses in the period in which they
are incurred are:
 abnormal amounts of wasted materials, labour or
other production costs;
 storage costs, unless those costs are necessary in
the production process before a further production
stage;
 administrative overheads that do not contribute to
bringing inventories to their present location and
condition; and selling costs.
8-12
 Cost of inventories for service provider
 To the extent that service providers have inventories,
they measure them at the costs of their production.
 These costs consist primarily of the labour and other
costs of personnel directly engaged in providing the
service, including supervisory personnel, and
attributable overheads.
 Labour and other costs relating to sales and general
administrative personnel are not included but are
recognised as expenses in the period in which they
are incurred. The cost of inventories of a service
provider does not include profit margins or
non‑attributable overheads that are often factored
8-13into prices charged by service providers.
 Disclosures
The financial statements shall disclose:
 the accounting policies adopted in measuring
inventories, including the cost formula used;
 the total carrying amount of inventories and the
carrying amount in classifications appropriate to the
entity;
 the carrying amount of inventories carried at fair
value less costs to sell;
 the amount of inventories recognised as an expense
during the period;

8-14
 Disclosures
 the amount of any write‑down of inventories
recognised as an expense in the period
 the amount of any reversal of any write‑down that is
recognised as a reduction in the amount of
inventories recognised as expense in the period
 the circumstances or events that led to the reversal
of a write‑down of inventories
 the carrying amount of inventories pledged as
security for liabilities.

8-15
 INVENTORY ISSUES

Classification
Inventories are assets:
 items held for sale in the ordinary course of business, or
 goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandising or Manufacturing
Company Company

8-16
 INVENTORY ISSUES
ILLUSTRATION 8-1
Classification
 One inventory
account.
 Purchase
merchandise in
a form ready
for sale.

8-17 LO 1
 INVENTORY ISSUES
ILLUSTRATION 8-1
Classification
Three accounts
 Raw Materials
 Work in Process
 Finished Goods

8-18 LO 1
 INVENTORY ISSUES ILLUSTRATION 8-2
Flow of Costs through
Manufacturing and
Merchandising

Classification
Companies

8-19 LO 1
 INVENTORY ISSUES

Inventory Cost Flow

ILLUSTRATION 8-3

Two types of systems for maintaining inventory records — perpetual

system or periodic system.

8-20 LO 2
 Inventory Cost Flow

Perpetual System
1. Purchases of merchandise are debited to Inventory.

2. Freight-in is debited to Inventory. Purchase returns and

allowances and purchase discounts are credited to Inventory.

3. Cost of goods sold is debited and Inventory is credited for

each sale.

4. Subsidiary records show quantity and cost of each type of

inventory on hand.

The perpetual inventory system provides a

continuous record of the balance in both the
Inventory and Cost of Goods Sold accounts.
8-21 LO 2
 Inventory Cost Flow

Periodic System
1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net + 800,000
Goods available for sale900,000
Ending inventory - 125,000
Cost of goods sold $ 775,000

8-22 LO 2
 Inventory Cost Flow

Comparing Perpetual and Periodic Systems

Illustration: Fesmire Company had the following transactions
during the current year.

Record these transactions using the Perpetual and Periodic

systems.

8-23 LO 2
 Inventory Cost Flow ILLUSTRATION 8-4
Comparative Entries—
Perpetual vs. Periodic

8-24 LO 2
 Inventory Cost Flow

Illustration: Assume that at the end of the reporting period, the

perpetual inventory account reported an inventory balance of
$4,000. However, a physical count indicates inventory of $3,800 is
actually on hand. The entry to record the necessary write-down is
as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In

practice, companies sometimes report Inventory Over and Short in the
“Other income and expense” section of the income statement.

8-25 LO 2
 INVENTORY ISSUES

Inventory Control
All companies need periodic verification of the inventory records
 by actual count, weight, or measurement, with
 counts compared with detailed inventory records.

Companies should take the physical inventory

 near the end of their fiscal year,
 to properly report inventory quantities in their annual
accounting reports.

8-26 LO 2
 INVENTORY ISSUES

Basic Issues in Inventory Valuation

Companies must allocate the cost of all the goods available for
sale (or use) between the goods that were sold or used and
those that are still on hand.

ILLUSTRATION 8-5
Computation of Cost
of Goods Sold

8-27 LO 2
 Basic Issues in Inventory Valuation

Valuing inventories requires determining

1. The physical goods to include in inventory (who owns
the goods?—goods in transit, consigned goods, special
sales agreements).

2. The costs to include in inventory (product vs. period

costs).

3. The cost flow assumption to adopt (specific

identification, average-cost, FIFO, retail, etc.).

8-28 LO 2
 PHYSICAL GOODS INCLUDED IN
INVENTORY

A company should record inventory when it obtains legal title

to the goods.

ILLUSTRATION 8-6
Guidelines for Determining Ownership
8-29 LO 3
 GOODS INCLUDED IN INVENTORY

Goods in Transit
Example: LG (KOR) determines ownership by applying the
“passage of title” rule.
 If a supplier ships goods to LG f.o.b. shipping point, title
passes to LG when the supplier delivers the goods to the
common carrier, who acts as an agent for LG.
 If the supplier ships the goods f.o.b. destination, title
passes to LG only when it receives the goods from the
common carrier.
“Shipping point” and “destination” are often designated by a
particular location, for example, f.o.b. Seoul.

8-30 LO 3
 GOODS INCLUDED IN INVENTORY

Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art
merchandise to Sotheby’s Holdings (USA) (the consignee), who
acts as Williams’ agent in selling the consigned goods.
 Sotheby’s agrees to accept the goods without any liability,
except to exercise due care and reasonable protection from
loss or damage, until it sells the goods to a third party.
 When Sotheby’s sells the goods, it remits the revenue, less a
selling commission and expenses incurred, to Williams.
Goods out on consignment remain the property of the consignor
(Williams).

8-31 LO 3
 GOODS INCLUDED IN INVENTORY

Sales with Repurchase Agreements

Example: Hill Enterprises transfers (“sells”) inventory to Chase,
Inc. and simultaneously agrees to repurchase this merchandise at
a specified price over a specified period of time. Chase then uses
the inventory as collateral and borrows against it.
 Essence of transaction is that Hill Enterprises is financing its
inventory—and retains control of the inventory—even though it
transferred to Chase technical legal title to the merchandise.
 Often described in practice as a “parking transaction.”
 Hill should report the inventory and related liability on its books.

8-32 LO 3
 GOODS INCLUDED IN INVENTORY

Sales with Rights of Return

Example: Quality Publishing Company sells textbooks to Campus
Bookstores with an agreement that Campus may return for full
credit any books not sold. Quality Publishing should recognize
a) Revenue from the textbooks sold that it expects will not be
returned.
b) A refund liability for the estimated books to be returned.
c) An asset for the books estimated to be returned which reduces
the cost of goods sold.
If Quality Publishing is unable to estimate the level of returns, it
should not report any revenue until the returns become predictive.
8-33 LO 3
 WHAT’S YOUR PRINCIPLE
NO PARKING!

In one of the more elaborate To foil auditors’ attempts to verify the

accounting frauds, employees at existence of the inventory, Kurzweil
Kurzweil Applied Intelligence Inc. employees moved the goods from
(USA) booked millions of dollars in warehouse to warehouse. To cover the
phony inventory sales during a two- fraudulently recorded sales
year period that straddled two audits transactions as auditors closed in, the
and an initial public offering. They employees brought back the still-
dummied up phony shipping hidden goods, under the pretense that
documents and logbooks to support the goods were returned by
bogus sales transactions. Then, they customers. When auditors uncovered
shipped high-tech equipment, not to the fraud, the bottom dropped out of
customers, but to a public warehouse Kurzweil’s shares.
for “temporary” storage, where some
Source: Adapted from “Anatomy of a
of it sat for 17 months. (Kurzweil still Fraud,” Business Week (September 16,
had ownership.) 1996), pp. 90–94.

8-34 LO 3
 GOODS INCLUDED IN INVENTORY

Effect of Inventory Errors

ILLUSTRATION 8-7
Ending Inventory Misstated Financial Statement
Effects of Misstated
Ending Inventory

The effect of an error on net income in one year will be counterbalanced in the next,
however the income statement will be misstated for both years.

8-35 LO 3
 Ending Inventory Misstated
Illustration: Yei Chen Corp. understates its ending inventory by
HK$10,000 in 2015; all other items are correctly stated.
ILLUSTRATION 8-8
Effect of Ending Inventory
Error on Two Periods

8-36 LO 3
 GOODS INCLUDED IN INVENTORY

Effect of Inventory Errors

ILLUSTRATION 8-9
Purchases and Inventory Misstated Financial Statement
Effects of Misstated
Purchases and Inventory

The understatement does not affect cost of goods sold and net income because the
errors offset one another.

8-37 LO 3
 COSTS INCLUDED IN INVENTORY

Product Costs
Costs directly connected with bringing the goods to the buyer’s
place of business and converting such goods to a salable
condition.

Cost of purchase includes all of:

1. The purchase price.

2. Import duties and other taxes.

3. Transportation costs.

4. Handling costs directly related to the acquisition of the goods.

8-38 LO 4
 COSTS INCLUDED IN INVENTORY

Period Costs
Costs that are indirectly related to the acquisition or production
of goods.

Period costs such as

 selling expenses and,
 general and administrative expenses

are not included as part of inventory cost.

8-39 LO 4
 COSTS INCLUDED IN INVENTORY

Treatment of Purchase Discounts

Purchase or trade discounts are reductions in the selling prices
granted to customers.

IASB requires these discounts to be recorded as a reduction

from the cost of inventories.

8-40 LO 4
 Treatment of Purchase Discounts

**

ILLUSTRATION 8-11 * $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Entries under Gross and
Net Methods

8-41 LO 4
 WHICH COST FLOW ASSUMPTIONS TO
ADOPT?

Cost Flow Methods

 Specific Identification
or
 Two cost flow assumptions
► First-in, First-out (FIFO) or
► Average Cost

8-42 LO 5
 Cost Flow Methods
To illustrate the cost flow methods, assume that Call-Mart Inc.
had the following transactions in its first month of operations.

Calculate Goods Available for Sale

Beginning inventory (2,000 x €4) € 8,000
Purchases:
6,000 x €4.40 26,400
2,000 x €4.75 9,500
Goods available for sale €43,900

8-43 LO 5
 Cost Flow Methods

Specific Identification
 IASB requires in cases where inventories are not ordinarily
interchangeable or for goods and services produced or
segregated for specific projects.
 Cost of goods sold includes costs of the specific items sold.
 Used when handling a relatively small number of costly,
easily distinguishable items.
 Matches actual costs against actual revenue.
 Cost flow matches the physical flow of the goods.

 May allow a company to manipulate net income.

8-44 LO 5
 Specific Identification
Illustration: Call-Mart Inc.’s 6,000 units of inventory consists of 1,000
units from the March 2 purchase, 3,000 from the March 15 purchase, and
2,000 from the March 30 purchase. Compute the amount of ending
inventory and cost of goods sold.
ILLUSTRATION 8-12

8-45 LO 5
 Cost Flow Assumptions

Average-Cost
 Prices items in the inventory on the basis of the average
cost of all similar goods available during the period.

 Not as subject to income manipulation.

 Measuring a specific physical flow of inventory is often

impossible.

8-46 LO 5
 Average-Cost
ILLUSTRATION 8-13
Weighted-Average Method Weighted-Average
Method—Periodic Inventory

8-47 LO 5
 Average-Cost
ILLUSTRATION 8-14
Moving-Average Method Moving-Average Method—
Perpetual Inventory

In this method, Call-Mart computes a new average unit cost each

time it makes a purchase.

8-48 LO 5
 Cost Flow Assumptions

First-In, First-Out (FIFO)

 Assumes goods are used in the order in which they are
purchased.

 Approximates the physical flow of goods.

 Ending inventory is close to current cost.

 Fails to match current costs against current revenues on

the income statement.

8-49 LO 5
 First-In, First-Out (FIFO)

Periodic Inventory System ILLUSTRATION 8-15

FIFO Method—Periodic
Inventory

Determine cost of ending inventory by taking the cost of the most

recent purchase and working back until it accounts for all units in the
inventory.
8-50 LO 5
 First-In, First-Out (FIFO)

Perpetual Inventory System ILLUSTRATION 8-16

FIFO Method—
Perpetual Inventory

In all cases where FIFO is used, the inventory and cost of goods
sold would be the same at the end of the month whether a perpetual
or periodic system is used.

8-51 LO 5
 Inventory Valuation Methods—Summary

Comparison assumes periodic inventory procedures and the

following selected data.

8-52 LO 5
 Inventory Valuation Methods—Summary

ILLUSTRATION 8-17
Comparative Results of
Average-Cost and FIFO
Methods

8-53 LO 5
 Inventory Valuation Methods—Summary

When prices are rising, average-cost results in the higher cash

balance at year-end (because taxes are lower).

ILLUSTRATION 8-18
Balances of Selected
Items under Alternative
Inventory Valuation
Methods

8-54 LO 5