ACCOUNTING FOR INVENTORY (IAS 2)
Definition
Inventories are currents assets
 Held for sale in ordinary course of business
 In the process of the production for such sales (WIP)
 In the form of materials to be consumed in production process
Measurement of inventory
The standard IAS 2 stated that inventory should be measured at the lower of
i. Cost
ii. Net realizable value
Objective of IAS 2
The objective of IAS 2 is to prescribe the accounting treatment of inventories.
It provides guidance for determining the cost of inventories and for subsequent
recognition of an expense including any write down to Net Realizable Value. It
also provides guidance on the cost formula that are used to assign cost to
inventories
Recognition of Inventory as an Expense
Inventory may be recognised as an expense when:
a) Inventory is sold, its carrying amount is recognised as an expense.Cost of Sales/Cost of Goods Sold
b) Write-downs to net realizable value
c) Losses of inventory e.g. loss by fire or theft
Disclosures
The IAS requires the financial statements to disclose the following:
a) the accounting policies adopted and cost formula used;
b) the carrying amount of inventories: the total amount and
the amount in classifications appropriate to the entity;
c) the carrying amount of inventories carried at fair value less
costs to sell;
d) the amount of inventories recognised as an expense during
the period;
e) any write-down of inventories recognised as an expense in
the period;
f) any reversal of any write-down recognised as a reduction in
the amount of inventories recognised as an expense in the
period;
g) the circumstances or events that led to the reversal of a
write-down of inventories;
h) The carrying amount of inventories pledged as security for
liabilities.
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Cost of inventories
The cost of inventories will consist of all costs of:
1. Purchase
2. Costs of conversion
3. Other costs incurred in bringing the inventories to their present location
and condition
The above costs are discussed in detail below:
1. Costs of Purchase
It includes the following:
 purchase price
 import duties and other taxes, excluding those subsequently
recoverable from the taxation authorities
 transport, handling and other costs directly attributable to the
acquisition of materials, finished goods and services
Note
Trade discounts / rebates are deducted if not already deducted from the
purchase price.
Example 1
XYQ Ltd purchased raw materials for Tshs 125 million less a rebate of 2%. It
paid Tshs 25 million as import duty, including Tshs10 million towards
countervailing duty. According to local tax laws, it will get a credit of the
amount paid towards countervailing duty, while determining its excise duty
liability. It spent ocean freight of Tshs3 million, clearing agent’s charges of
Tshs2 million, Tshs4 million on warehouse rent and Tshs1.5 million on the
watchman’s salary.
Required: Determine the cost of materials
2. Costs of Conversion
Costs of conversion Costs of conversion of inventories consist of two main
parts.
1. Costs directly related to the units of production, eg direct materials,
direct labor e.g. a worker spent 6 hours on completing the article; the
wages paid to the worker for the time can be directly related to the units
of production
2. Fixed (allocated based on normal capacity) and variable production
overheads that are incurred in converting materials into finished goods,
allocated on a systematic basis.
Fixed Production Overheads
 Allocation is based on normal capacity.
 Normal capacity is the expected average over a number of periods, after
taking into account the loss of capacity due to normal maintenance.
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 If there is a low production, overhead allocated to each unit is not
increased.
 Unallocated overheads are recognised as an expense in the period in
which they are incurred.
Example 2
ZANZY Co’s normal capacity is 100,000 units per annum. Budgeted fixed
production overheads are Tshs 200,000 per annum. Raw material and wages
per unit are Tshs15.
Actual production is 98,000 units and actual fixed overheads are Tshs
203,000.
Required: Determine the Inventory value
Other Costs
Other costs any other costs should only be recognised if they are incurred in
bringing the inventories to their present location and condition.
Example 4
A product is manufactured according to the specifications given by the
customer. Material cost is Tshs300 million and wages are Tshs130 million.
Professional fees of Tshs25 million are paid for having the product designed.
Required: Determine total cost
Costs excluded from the Cost of Inventory
The standard lists types of cost which would not be included in cost of
inventories. Instead, they should be recognised as an expense in the period
they are incurred.
1. Abnormal amounts of wasted materials, labor or other production costs
2. Storage costs (except costs which are necessary in the production process
before a further production stage)
3. Administrative overheads not incurred to bring inventories to their present
location and conditions
4. Selling costs e.g. commission paid to salesmen
5. Borrowing costs, except to the extent permitted by IAS 23 – Borrowing
costs
Measurement of inventories
Inventories shall be measured at the lower of cost and net realizable value.
Measure at a lower of Cost and NRV
Net Realizable value (NRV)
Selling price………………………….xxx
Less:
Cost to complete…………………… (xxx)
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Cost of selling ……………………….(xxx)
NRV……………………………………..xxx
Example 5
PQ manufactures components for the retail industry. The inventory is currently
valued at cost
The cost structure of the equipment is as follows
Cost per unit Selling price per unit
Production process, 1st stage
1,000
1,050
Conversion cost, 2nd stage
500
Finished product
1,500
1,700
The selling costs are Tshs 10 per unit and PQ has 100,000 unit at the first
stage of production and 200,000 units of finished products. Shortly after the
year end a competitor released a new model and this resulted in PQ having to
reduce its selling price to Tshs 1,450 for the finished product and Tshs 950 for
first stage of the production.
REQUIRED: Calculate the value of closing inventory to be included in
PQ’s financial statements at the reporting period
Cost Formula
A cost formula is required to determine the value of material issued and
material remaining in inventory. The selection of the correct cost formula
depends upon the nature of the items.
Specific Identification Method
This method is applied to items that are not ordinarily interchangeable and
goods and services produced and segregated for specific projects. Specific costs
are attributed to the items of inventory.
Example 6
For special made-to-order furniture, specific costs of material and labor used
therein are identified and included in the cost.
Other Methods Allowable under IAS 2
Either of the following two methods is to be used for items not covered under
the specific identification method above. This means that the two methods are
for ordinarily interchangeable goods and services.
First in First Out (FIFO):
This method assumes that the item which came first into inventory (by way of
purchase or production) went out first (as sales or consumption). This means
that the items remaining in hand are those which were purchased the last.
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This is an assumption for the purpose of determining the cost, and the actual
movement of the goods may or may not be in that manner. However, generally,
the storekeepers ensure that the oldest items are moved out first.
Weighted Average:
Total cost of material (opening inventory plus subsequent purchases) is divided
by the total quantity (opening inventory plus subsequent purchases). This is
done either after every purchase or periodically.
Weighted Average = Total cost of material
Total quantity of material
Note
The Last In First Out method (LIFO) is not permitted by IAS 2
Example 7
The following details are available from Bakers Point Ltd:
Date
Details
Quantity
Rate
(Tshs)
01/4/2012
Opening
inventory
500
20,000
04/4/2012
Purchase
150
22,000
08/4/2012
Issue
200
Determine the value of the inventory as at 8 April 2012 under the FIFO and
Weighted Average methods.
Example 8
The following details are available from Bakers Point Ltd:
Date
Details
Quantity Rate
(Tshs)
01/4/2012 Opening inventory
500 20,000
04/4/2012 Purchase
150 22,000
08/4/2012 Issue
600
Determine the value of the inventory as at 8 April 2012 under the FIFO and
Weighted Average methods.
b) Approximation Techniques for the Measurement of Costs
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As seen above, normally cost is to be determined for the measurement of
inventories. However, the IAS provides for some alternatives where,
instead of actual costs, some alternative amounts may be used. These are
called approximation ‘techniques’ and are discussed below:
i) Standard Cost Method:
Standards based on the normal level are decided for the elements
of cost such as materials, labor and overheads. The standard
costs are used for the valuation of inventories and the issues of
materials.
ii) Retail Method:
Retailers sometimes use this method if there are large numbers
of rapidly-changing items with similar margins for which it is
impracticable to use other costing methods. Sales value is
taken as a starting-point, and the gross margin percentage is
deducted from that, to arrive at the value of inventory.
Example 9
XLS Inc, a dealer in garments, has thousands of items in inventory. It applies
the retail method. Its average gross margin is 20%. The sales price of a carton
of 10 shirts is Tshs130,000.
Required: Determine the value of each shirt
Net Realizable Value
Net realizable value is the estimated selling price in the ordinary course of
business, less estimated costs of completion and estimated costs necessary to
make the sale.
IAS 2 Pare 6
Costs are compared with the realizable value since the inventories are to be
measured at the lower of the two. This is based on the view that assets should
not be carried at a value which is in excess of their realizable value
Example 10
All Amounts in TSh. ‘000’
Group
Sales
Costs to
Quantit Cost per price per Completi Selling
Item
y
unit
unit
on
costs
P
1
500
2
5
Q
2
280
5
8
P
3
320
3
9
P
4
170
4
8
Q
5
460
2
7
Required: Determine the value of inventory
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