IAS 2 - INVENTORIES
SCOPE
o IAS 2 does not apply to
• Financial instruments (IAS 32, IFRS 9); and
• Biological assets (IAS 41)
• Measurement principles of IAS 2 do not apply to (FYI – for noting):
• Certain assets measured at NRV i.t.o well established practices (biological assets / mineral
resources); and
• Commodity broker traders measuring inventories at fair value less costs to sell (FVLCTS): FV
movements get charged to P/L
DEFINITION –
Assets
- Held for sale in the ordinary course of business OR
- In the process of production for sale OR
- In the form of materials or supplies to be consumed in the production process or in the rendering of
services
MEASUREMENT
- Inventories are measured at the lower of
• Cost; or
• Net realisable value (NRV)
- Cost =
• costs of purchase
(purchase price + import duties + non-recoverable taxes + transport costs + handling
costs + other direct costs of acquisition – trade discounts – subsidies on purchases)
(.11);
• costs of conversion
(direct raw material costs + direct labour costs + indirect costs [fixed and variable
production overheads]) (.12);
• other costs incurred to bring the inventories to their present location and condition
(costs of designing products for specific customers & borrowing costs in the case of
inventories with a long maturing process) (.15).
• IAS 23 Borrowing Costs identifies limited circumstances where borrowing costs are included
in the cost of inventories (IAS 2.17);
• IFRS 9 Financial instruments identifies limited circumstances where exchange differences
are included in the cost of inventories.
Excludes
abnormal amounts of wasted materials, labour and other production costs;
fixed production overhead costs not apportioned (under/over recovery of overhead costs);
storage costs (unless part of production process, eg. storage of maturing wine);
administrative costs;
selling costs (.16).
COST OF PURCHASE
Purchase price (cash)
+ Import duties & other non-refundable taxes
+ Transport & handling costs
+ Other costs directly attributable to acquisition
(i.e. related and necessary to bringing them to present location and condition)
- Deduct trade / settlement discounts, rebates and similar items
- Abnormally high = area of judgement
- Prevents inventories from being carried at > NRV
Before reallocation the over absorption had both a price and volume variance
This volume variance arises because the budgeted base differed significantly from actual units
Therefore, we reallocate FOHs based on actual, this eliminates the volume variance
The difference in over/under allocation is taken into account in the inventory valuation and therefore found
in CoS or closing inventory
MEASUREMENT BASIS
RETAIL METHOD
Sales less GP% = cost
BY-PRODUCTS
• Cost of conversion of each product are not separately identifiable?
• Allocate on a rational & consistent basis
• Option 1:
Using relative stand-alone selling prices of products to split costs
• Option2:
If by-products are immaterial
• Measure by-product at NRV
• Deduct this NRV from cost of main product produced
• Seen as negative assets
STANDARD COST
Can be measured at standard if takes into account normal losses (expected variances)
Risk that standard is outdated
SUBSEQUENT MEASUREMENT
Lower of: Cost
NRV
No cost benefit for measuring RA therefore NRV is used
NRV is an entity specific value
NET REALISABLE VALUE
Defined - 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
The cost of inventories is irrecoverable under the following circumstances:
- inventories are damaged;
- inventories are wholly/partially obsolete;
- selling prices of the inventories have declined;
- estimated costs of completion have increased;
- estimated selling costs have increased (.28).
PRINCIPLE
Assets should not be carried in excess of the amounts expected to be realised from their sale/ use
In estimating NRV, entity to consider purpose that inventory is held for
• Inventories held for specific contracts: NRV determined with reference to contract and not general
sales
If raw materials are used in a
NRV = Impairment of inventory
product, then only write materials
CA > NRV = Write down of inventory (P/L item) to NRV if product is also below cost
NRV = Estimated SP – cost to sell
CONSIDERATIONS
New assessment of NRV is made periodically
Write-downs may subsequently be reversed
But limited to the amount of the original write-down
COST FORMULAS
- Specific identification
- items that are not ordinarily interchangeable, and
- goods and services produced and segregated for specific projects.
- FIFO
- Weighted average
DISCOUNTS AND REBATES
E.g. Bravo Ltd. purchased inventory to the value of R114000. This amount is subject to a settlement
discount of 2% if settled within 10 days.
CATEGORIES OF INVENTORY
• Raw materials
• Work in progress
• Finished goods
• Merchandise
• Consumables
RAW MATERIALS
Defined - The cost of goods purchased for use in manufacture and not yet introduced into production at the
reporting date
Where is it used?
• Journals
• T-accounts
• Cost per unit
WORK-IN-PROGRESS
Defined - The cost of raw material on which work has been started, but not yet finished, plus the direct labour
cost applied to this material, plus a share of fixed production overhead costs and any other directly
attributable costs
What does this all include?
Direct labour, Direct materials, variable costs, fixed costs (ALLOCATED).
Fixed costs
Accounting vs Financial management
Budgeted overheads (manufacturing)
budgeted units (norma capacity )
= Allocation rate
Actual capacity x allocation rate = fixed costs absorbed
This is usual based on hours, such as direct labour hours.
Absorbed – Fixed costs can be over or under allocated.
Over allocated = income
Under allocated = expense
FINISHED GOODS
Defined - The cost of the completed but unsold goods on hand at the end of the year
Finished goods is used to calculated cost of sales:
Opening balance + WIP transferred – Closing balance = Cost of sales
You can use the formula to solve for (x).
MERCHANDISE
Defined - The cost of goods purchased for resale and still on hand at the reporting date.
This is inventory used for retail (PnP)
CONSUMABLE INVENTORY
Defined - The cost of incidental materials consumable in the production process, not yet incorporated into the
end product, including items such as oil and cleaning materials.
This is the indirect materials used in production
PERIODIC VS PERPETUAL
See additional explanatory notes on blackboard as well as notes from prior studies
Tip: If a question is silent on which system is used – assume the perpetual system
DISCLOSURE
The financial statements should disclose the following:
- the accounting policies adopted in measuring inventories, including the cost formula used;
- the total carrying amount of inventories and the carrying amount in classification appropriate to the
entity;
- the carrying amount of inventories carried at fair value less cost to sell;
- the amount of inventories recognised as an expense during the period;
- the amount of any write-down of inventories recognised as an expense during the period;
- the amount of any reversal of any write-down to net realisable value;
- the circumstances or events that led to the reversal of a write-down of inventories; and
- the carrying amount of inventories pledged as security for liabilities (.36).
DEFERRED TAX
IAS 2 (AC 108) Inventories forms the basis for most calculations in terms of section 22 of the Income Tax Act,
dealing with trading stock (e.g. cost of inventories, opening and closing stock etc.). The cost of inventories sold
is deductible for taxation purposes in terms of section 11(a) of the Income Tax Act, while section 22(1) and
22(2) deal with closing and opening trading stock respectively.
It is recommended that you be sure to understand section 22 of the Income Tax Act very well. From an
accounting point of view, we will assume that the requirements are met in terms of section 22, e.g. write-offs
of inventory to net realisable value: SARS will only allow these write-offs as a tax deduction for trading stock
that is not shares. Know the responsibilities of taxpayers in terms of Practice Note 36 (focusing on ITC 1489).
Due to time constraints, the requirements of the Income Tax Act cannot be dealt with in detail in Accounting,
but these will be lectured in Taxation and will form a very important part of the topic.
You may therefore assume that there are normally no differences between the accounting and taxation
treatments of inventory/trading stock for our purposes and that no deferred taxation will therefore be
applicable. The only exception here may be when SARS does not allow the full inventory write-down as a tax
deduction. The inventory write-down is then treated as a normal provision for deferred tax purposes (i.e. tax
base equals carrying amount less amount deductible in future for tax purposes).
Also note that borrowing cost capitalised to the cost of the inventory is also an acceptable treatment in terms
of the Income Tax Act. It therefore does not have any deferred tax implications.
Note that borrowing costs are in effect deducted for tax purposes due to its inclusion in the cost of inventories
and therefore in cost of sales, but the relevant portion is added back due to the closing trading stock in terms
of section 22(1) only being deductible in the year that the trading stock is sold. (The closing trading stock also
includes a portion of capitalised borrowing costs).
This is however not the case with other assets (excluding inventory and manufacturing buildings). Refer to the
IAS 23 module for the deferred tax treatment of borrowing costs included in the cost price of other assets (e.g.
PPE). These will be dealt with in detail in the module on property, plant and equipment (PPE). For tax purposes
the borrowing costs are only added to the tax bases for inventories and manufacturing buildings.