IAS 2 Inventories sets out how to determine the cost of inventories, when that cost is recognized as an expense (including any write-down to net realisable value), and what cost formulas are permitted for assigning costs to inventory items. Inventories are usually one of the largest and most judgment-heavy line items on the balance sheet of a trading or manufacturing business, which makes getting the costing policy right — and applying it consistently — important for both compliance and decision-making. This is Part 1 of a three-part series on IAS 2. It covers the standard’s scope, how the cost of inventory is built up, and the cost formulas IFRS permits. Part 2 covers net realisable value, write-downs, reversals and disclosure, and Part 3 offers a free interactive calculator for FIFO and weighted average costing.

Scope and Objective of IAS 2

IAS 2 applies to all inventories except work in progress arising under construction contracts (including directly related service contracts), which is covered by IFRS 15 Revenue from Contracts with Customers; financial instruments within the scope of IFRS 9; and biological assets related to agricultural activity and agricultural produce at the point of harvest, which are covered by IAS 41 Agriculture. Once harvested, agricultural produce becomes inventory and is then measured under IAS 2.

The standard also provides limited measurement exemptions — rather than a full scope exclusion — for two groups of entities. Producers of agricultural and forest products, agricultural produce after harvest, and minerals and mineral products may measure those inventories at net realisable value at certain stages of production, in accordance with well-established industry practice. Commodity broker-traders who buy or sell commodities for others, or on their own account, may measure their inventories at fair value less costs to sell, with changes in that value recognized in profit or loss. Where either measurement basis is used, only the disclosure requirements of IAS 2 relating to the measurement basis apply, not its cost-determination rules.

What Counts as Inventory

IAS 2 defines inventories as assets that are: 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 rendering services. In practice this covers merchandise purchased for resale, land and other property held for resale, finished goods produced by the entity, work in progress, and raw materials and supplies awaiting use in production.

Initial Measurement: The Lower of Cost and Net Realisable Value

Inventories are measured at the lower of cost and net realisable value (LCNRV). Cost is the amount actually incurred to bring the inventory to its present location and condition; 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. Net realisable value, write-downs, and reversals of write-downs are the subject of Part 2 of this series — this part focuses on how cost itself is determined.

Under IAS 2, the cost of inventories comprises three components: the costs of purchase, the costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Each is addressed below.

Costs of Purchase

The costs of purchase of inventories comprise the purchase price, import duties and other non-recoverable taxes, 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.

Costs of Conversion

For inventories a business manufactures rather than purchases ready-made, cost also includes the costs of conversion: costs directly related to the units of production, such as direct labor, plus a systematic allocation of fixed and variable production overheads incurred in converting materials into finished goods.

Fixed production overhead — costs such as factory depreciation, maintenance of factory buildings and equipment, and the cost of factory management and administration — is allocated to units of production based on the normal capacity of the production facilities, being the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking planned maintenance into account. The actual level of production may be used if it approximates normal capacity. Crucially, the amount of fixed overhead allocated to each unit of production is not increased simply because production is abnormally low or the plant is idle; unallocated overheads are recognized as an expense in the period they are incurred rather than deferred into inventory cost. In periods of abnormally high production, the amount of fixed overhead allocated to each unit is decreased so that inventories are not measured above cost. Variable production overheads, by contrast, are allocated to each unit on the basis of the actual use of the production facilities.

Joint Products and By-Products

A production process may result in more than one product being produced simultaneously — as with joint products, or a main product together with a by-product. Where the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis, such as the relative sales value of each product at the stage in the production process at which the products become separately identifiable. Most by-products are, by nature, immaterial; where this is the case they are often measured at net realisable value, and this value is deducted from the cost of the main product.

Other Costs, and Costs Excluded from Inventory

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, non-production overheads or the costs of designing products for specific customers may qualify in certain circumstances.

Certain costs are specifically excluded from the cost of inventories and are instead recognized as expenses in the period they are incurred: abnormal amounts of wasted materials, labor, 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. Where an arrangement effectively contains a financing element — for example, inventory is purchased on deferred settlement terms significantly beyond normal credit terms — the difference between the purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of financing, rather than added to the cost of the inventory.

Cost Formulas

Where inventory items are not ordinarily interchangeable, and for goods or services produced and segregated for specific projects, IAS 2 requires the cost of each item to be assigned using specific identification of its individual costs.

For inventories that are ordinarily interchangeable, IAS 2 permits two cost formulas: first-in, first-out (FIFO), which assumes that the items purchased or produced first are sold first, so that items remaining in inventory at period end are those most recently purchased or produced; and weighted average cost, under which the cost of each item is determined from the weighted average of the cost of similar items at the start of the period and the cost of similar items purchased or produced during the period. The weighted average may be calculated on a periodic basis or as each additional shipment is received, depending on the entity’s circumstances. An entity must use the same cost formula for all inventories that have a similar nature and use; a different formula may be justified where inventories have a different nature or use, for example where they are used in different geographical locations or for different business segments.

The last-in, first-out (LIFO) formula is not permitted under IFRS. This is one of the more consequential differences between IFRS and US GAAP, which does permit LIFO; entities reporting under both frameworks, or converting from US GAAP to IFRS, need to reassess their inventory costing policy and the resulting effect on both the balance sheet and cost of sales.

Techniques for Measuring Cost

IAS 2 permits the use of certain costing techniques for convenience, provided the results approximate cost. The standard cost method takes into account normal levels of materials and supplies used, labor, efficiency, and capacity utilization; standard costs are reviewed regularly, and revised where necessary, in light of current conditions. The retail method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods — cost is determined by reducing the sales value of the inventory by the appropriate percentage gross margin, with an average percentage used for each retail department when items within it have similar margins.

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