SUMMARY OF PAS 2 INVENTORIES
Objective of PAS 2
The objective of PAS 2 is to prescribe the accounting
treatment for inventories. It provides guidance for
determining the cost of inventories and for subsequently
recognising an expense, including any write-down to net
realisable value. It also provides guidance on the cost
formulas that are used to assign costs to inventories.
Scope
Inventories include assets held for sale in the ordinary
course of business (finished goods), assets in the
production process for sale in the ordinary course of
business (work in process), and materials and supplies
that are consumed in production (raw materials). [PAS
2.6]
However, PAS 2 excludes certain inventories from its
scope: [PAS 2.2]
I.
work in process arising under construction contracts
(see PAS 11)
II. financial instruments (see PAS 39)
III. biological assets related to agricultural activity and
agricultural produce at the point of harvest (see PAS
41).
Also, while the following are within the scope of the
standard, PAS 2 does not apply to the measurement of
inventories held by: [PAS 2.3]
 producers of agricultural and forest products,
agricultural produce after harvest, and minerals and
mineral products, to the extent that they are measured
at net realisable value (above or below cost) in
accordance with well-established practices in those
industries. When such inventories are measured at net
realisable value, changes in that value are recognised
in profit or loss in the period of the change.
 commodity brokers and dealers who measure their
inventories at fair value less costs to sell. When such
inventories are measured at fair value less costs to
sell, changes in fair value less costs to sell are
recognised in profit or loss in the period of the change.
PAS 23 Borrowing Costs identifies some limited
circumstances where borrowing costs (interest) can be
included in cost of inventories that meet the definition of
a qualifying asset. [PAS 2.17 and PAS 23.4]
Inventory cost should not include: [PAS 2.16 and 2.18]
 abnormal waste
 storage costs
 administrative overheads unrelated to production
 selling costs
 foreign exchange differences arising directly on the
recent acquisition of inventories invoiced in a foreign
currency
 interest cost when inventories are purchased with
deferred settlement terms.
The standard cost and retail methods may be used for the
measurement of cost, provided that the results
approximate actual cost. [PAS 2.21-22]
For inventory items that are not interchangeable, specific
costs are attributed to the specific individual items of
inventory. [PAS 2.23]
For items that are interchangeable, PAS 2 allows the FIFO
or weighted average cost formulas. [PAS 2.25] The LIFO
formula, which had been allowed prior to the 2003
revision of PAS 2, is no longer allowed.
The same cost formula should be used for all inventories
with similar characteristics as to their nature and use to
the entity. For groups of inventories that have different
characteristics, different cost formulas may be justified.
[PAS 2.25]
Write-Down to Net Realisable Value
NRV is the estimated selling price in the ordinary course
of business, less the estimated cost of completion and the
estimated costs necessary to make the sale. [IAS 2.6] Any
write-down to NRV should be recognised as an expense in
the period in which the write-down occurs. Any reversal
should be recognised in the income statement in the
period in which the reversal occurs. [PAS 2.34]
Fundamental Principle of PAS 2
Expense Recognition
Inventories are required to be stated at the lower of cost
and net realisable value (NRV). [PAS 2.9]
PAS 18 Revenue addresses revenue recognition for the
sale of goods. When inventories are sold and revenue is
recognised, the carrying amount of those inventories is
recognised as an expense (often called cost-of-goodssold). Any write-down to NRV and any inventory losses
are also recognised as an expense when they occur. [PAS
2.34]
Measurement of Inventories
Cost should include all: [PAS 2.10]
 costs of purchase (including taxes, transport, and
handling) net of trade discounts received
 costs of conversion (including fixed and variable
manufacturing overheads) and
 other costs incurred in bringing the inventories to their
present location and condition
Disclosure
Required disclosures: [PAS 2.36]
 accounting policy for inventories
 carrying amount, generally classified as merchandise,
supplies, materials, work in progress, and finished
goods. The classifications depend on what is
appropriate for the entity
 carrying amount of any inventories carried at fair value
less costs to sell
 amount of any write-down of inventories recognised as
an expense in the period
 amount of any reversal of a writedown to NRV and the
circumstances that led to such reversal
 carrying amount of inventories pledged as security for
liabilities
 cost of inventories recognised as expense (cost of
goods sold). PAS 2 acknowledges that some
enterprises classify income statement expenses by
nature (materials, labour, and so on) rather than by
function (cost of goods sold, selling expense, and so
on). Accordingly, as an alternative to disclosing cost of
goods sold expense, IAS 2 allows an entity to disclose
operating costs recognised during the period by nature
of the cost (raw materials and consumables, labour
costs, other operating costs) and the amount of the
net change in inventories for the period). [PAS 2.39]
This is consistent with PAS 1, which allows
presentation of expenses by function or nature.
ADDITIONAL LECTURE NOTES
the proceeds of the “sale”, which more accurately in
substance is a short-term loan secured by inventory
as collateral.
Inventory cost formulas
The purpose of an inventory valuation method is to
allocate the total inventory cost of good available for sale
during the period between cost of goods sold and ending
inventory.
Specific identification

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Whose inventory is it?
Goods in transit

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Shipping terms determine when title to goods passes
to the purchaser.
a. FOB (free on board) shipping point—title passes
to the buyer with the loading of goods at the
point of shipment.
b. FOB destination—legal title does not pass until
the goods are received by the buyer.
Goods shipped FOB shipping point belong to the buyer
while they are in transit and should normally be
included in the buyer’s inventory while in transit.
Goods shipped FOB destination belong to the seller
while in transit and are normally included in the
seller’s inventory.

Required for inventories that are not ordinarily
interchangeable and goods or services produced
and segregated for specific projects.
The original cost of each item is identified, resulting
in actual costs being accumulated for the specific
items on hand and sold.
This method is consistent with the physical flow of
goods (though note, it is not required that one has to
choose a cost-flow method which corresponds to the
actual, underlying physical flow of goods).
Though theoretically attractive and useful when each
inventory item is unique and has a high cost, it is
frequently not economically feasible (even if taking
into account advances in technology), particularly
where inventory is composed of a great many items
or identical items acquired at different times and at
different prices.
It is subject to manipulation, as seller has the
flexibility of selectively choosing specific items of
higher/lower-costing
inventory
depending
on
particular income goals at the time of sale.
It is the least common method observed in practice.
Average cost method
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This method assigns the same average cost to each
unit.
Based on the assumption that goods sold should be
charged at an average cost, with the average being
weighted by the number of units acquired at each
price.
It provides the same cost for similar items of equal
utility.
It does not permit profit manipulation.
Its limitation is that inventory values may lag
significantly behind current prices in periods of rapidly
rising or falling prices.
Goods on consignment


Goods held by the dealer (consignee) for which title is
held by the shipper (consignor).
Consigned goods are included in the inventory of the
consignor.
Conditional sales, installment sales, and repurchase
agreements

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If title to the goods is retained by the seller, the seller
may report as an asset the cost of the goods less the
purchaser’s equity in the goods such as established
by collections.
Generally however, in the usual case where the
possibilities of default or return are low, the seller, in
anticipation of contract completion and ultimate
passing of title, will recognize the transaction as a
regular sale and remove the goods from reported
inventory at the time of sale.
Repurchase agreements result in no sale being
recorded; the inventory is thus not removed from the
books, and instead the “seller” records a liability for
First-in, first-out method (FIFO)
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The first goods purchased are the first goods sold.
Using the FIFO method, the accountant computes the
cost of goods sold and ending inventory as if the first
items purchased are the first to be sold, leaving the
most recently purchased items in inventory.
This often matches the physical flow of goods.
FIFO affords little opportunity for profit manipulation.
FIFO best approximates the current replacement value of
ending inventory.
Comparison of methods: cost of goods sold and ending
inventory
The average cost method:

Differs from the other methods in that no assumption
is made about the sale of specific units.

Rather, all sales are assumed to be of the “average”
unit at the average cost per unit.

The gross profit margin tends to follow a similar
pattern to FIFO in response to changing prices.

Generally provides inventory values similar to FIFO
values, since average costs are heavily influenced by
current costs.
FIFO:

In a period of rising prices, matches oldest low-cost
inventory with rising sales prices, thus expanding the
gross profit margin.

In a period of declining prices, oldest high-cost
inventory is matched with declining sales prices, thus
narrowing the gross profit margin.

Inventories are reported on the balance sheet at or
near current costs.
Specific identification:

Can produce any variety of results depending on
which particular units are selected for shipment.
Inventory systems
Periodic inventory system
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An inventory system in which only revenue is
recorded each time a sale occurs; the inventory
balance is determined by a periodic physical
inventory.
Using the periodic system, items must be physically
counted to determine quantities on hand.
Quantities of items sold are determined indirectly by
subtracting the units on hand from the sum of the
units in the beginning inventory and units purchased
during the year.
with LCM, in the period in which the inventory price
decline took place).

Acquisition of the goods in a subsequent period is also
recorded.
1. Purchases are recorded at current market value.
2. Difference between current market value of goods
and total amount owed per the purchase
commitment is reflected by the removal of the
estimated loss on purchase commitments account
(a balance sheet account created above).

Current loss recognition is not appropriate when:
1. Commitments can be cancelled,
2. Commitments provide for price adjustment,
3. Hedging transactions prevent losses, or
4. Declines do not suggest reductions in sales prices.

If, prior to delivery, the market price increases, the
estimated loss on purchase commitments account is
reduced and a gain is recorded, though such
“recovery” can only be recognized to the extent of the
original loss recorded.
Using inventory information for financial analysis
Inventory balances are often used to measure a
company’s efficiency in using that asset to generate sales.
Inventory turnover evaluates the inventory position and
the appropriateness of its size (cost of goods sold/
average inventory).
Number of days’ sales in inventory gives average time it
takes to turn over the inventory (Average inventory/
average daily cost of goods sold) (or number of days in
the year/ inventory turnover rate).
Perpetual inventory system
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An inventory system which provides a continuous
summary of goods on hand.
Entries for sales, cost of goods sold, and the reduction
of inventory are recorded for each sales transaction.
A continuous record of quantities in inventory and
items sold is maintained.
Benefits of a perpetual system.
1. Provides a continuous check and control
mechanism on inventory.
2. Facilitates purchasing and production planning
3. Ensures adequate on-hand inventories
4. Helps identify and measure the magnitude of
inventory shrinkage.
5. Advances in, and cost reductions relating to,
technology have made perpetual systems much
more feasible, and it’s a good thing – today’s fastpaced,
competitive
business
environment
magnifies the importance of a perpetual system’s
benefits.
Purchase commitments

A lock on the inventory purchase price in advance. An
executory contract (an exchange of promises about
future actions).

No journal entry is required to record an asset and
liability at the commitment date.

However, when price declines take place subsequent
to the commitment and it is outstanding at the end of
an accounting period, the loss is recorded just as
losses with goods on hand are recognized (i.e., as
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