Cost is only half of how IAS 2 requires inventories to be measured. Whenever net realisable value falls below cost, the inventory must be written down — and IAS 2 is precise about how that write-down is estimated, recognized, and, if conditions improve, reversed. This is Part 2 of a three-part series on IAS 2. It covers how net realisable value is estimated, when and how write-downs and reversals are recognized, how the write-down mechanics feed into cost of sales, and what IAS 2 requires an entity to disclose about its inventories. Part 1 covered scope and cost measurement, and Part 3 offers a free interactive calculator that applies these rules to a worked FIFO and weighted average example.

Net Realisable Value: Definition and Estimation

Net realisable value (NRV) 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. It is important not to confuse NRV with fair value: fair value reflects the price at which an orderly transaction would take place between market participants at the measurement date, whereas NRV is an entity-specific value based on how the entity itself expects to realize the inventory. The two may differ, and net realisable value does not always equal fair value less costs to sell.

Estimates of NRV are based on the most reliable evidence available at the time the estimates are made of the amount the inventories are expected to realize, and take into consideration the purpose for which the inventory is held. Fluctuations of price or cost directly relating to events occurring after the end of the period are also taken into account to the extent that they confirm conditions existing at the end of the period — the same principle used to identify adjusting events under IAS 10.

Inventory Held to Satisfy Firm Contracts

The purpose for which inventory is held matters. Inventory held to satisfy firm sale contracts is measured based on the contract price. If the quantity specified in sale contracts is less than the inventory quantities held, the NRV of the excess is based on general selling prices. Provisions may arise from firm sale contracts in excess of the inventory quantities held, and from firm purchase contracts — these are addressed under IAS 37 Provisions, Contingent Liabilities and Contingent Assets rather than under IAS 2 itself.

When Materials and Supplies Are, and Are Not, Written Down

Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above cost. However, when a decline in the price of materials indicates that the cost of the finished products will exceed net realisable value, the materials are written down to net realisable value — and in such circumstances, the current replacement cost of the materials is often the best available measure of their net realisable value.

This distinction reflects a broader principle underlying IAS 2: assets should not be carried in the financial statements at more than the amounts expected to be realized from their sale or use.

Recognizing a Write-Down, and Reversing One

Write-downs to net realisable value are usually made on an item-by-item basis. In some circumstances, it may be appropriate to group similar or related items — for example, items of inventory relating to the same product line that have similar purposes or end uses and are produced and marketed in the same geographical area. It is not appropriate to write inventories down on the basis of a broad classification, such as writing down all finished goods, or all inventories in a particular industry or geographical segment, without item-level or item-group support.

The amount of any write-down of inventories to net realisable value, and all losses of inventories, is recognized as an expense in the period the write-down or loss occurs.

Reversals work differently, and asymmetrically. The amount of any reversal of a write-down, arising from an increase in net realisable value, is recognized as a reduction in the amount of inventories recognized as an expense in the period the reversal occurs. This happens when the circumstances that previously caused inventories to be written down below cost no longer exist, or when there is clear evidence of an increase in net realisable value because of changed economic circumstances. Critically, a reversal is limited to the amount of the original write-down, so that the new carrying amount is always the lower of cost and the revised net realisable value — inventory is never marked up above its original cost, only the earlier write-down is reversed.

How Write-Downs Flow Into Cost of Sales

When inventories are sold, their carrying amount is recognized as an expense — cost of sales — in the period the related revenue is recognized. The amount of any write-down of inventories to net realisable value, and all losses of inventories, are recognized as an expense in the period the write-down or loss occurs, and the amount of any reversal is recognized as a reduction in that expense in the period the reversal occurs. Some inventories may instead be allocated to other asset accounts — for example, inventory used as a component of a self-constructed item of property, plant and equipment — in which case they are recognized as an expense over the useful life of that asset rather than as cost of sales.

Disclosure Requirements

IAS 2 requires the financial statements to 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, such as merchandise, production supplies, materials, work in progress, and finished goods;
• the carrying amount of inventories carried at fair value less costs to sell;
• the amount of inventories recognized as an expense during the period (cost of sales);
• the amount of any write-down of inventories recognized as an expense in the period;
• the amount of any reversal of a write-down that is recognized as a reduction in expense in the period, together with the circumstances or events that led to the reversal; and
• the carrying amount of inventories pledged as security for liabilities.

Together, these disclosures give financial statement users visibility not just into how much inventory an entity holds, but into the judgment calls behind its carrying value — which cost formula was used, how much has already been expensed through cost of sales, and whether recent write-downs or reversals signal a change in the entity’s underlying business conditions.