IAS 2 Inventories
IAS 2 Inventories: The International Accounting Standards Board (IASB) developed and distributed IAS 2 as an international financial reporting standard to give advice on the value and categorization of inventories.
Inventory is defined by IAS 2 Inventories as an asset that consists of:
(a) kept for the purpose of sale in the normal course of business,
(b) throughout the manufacturing process for such a sale,
(c) in the form of goods or supplies to be used in the manufacturing or service-delivery process.
According to IAS 2 Inventories, inventory assets must be documented at the lowest of cost or net realisable value. The cost comprises not only the purchase price, but also conversion expenses, such as direct labour, that are incurred in getting inventory to its current state and location. IAS 2 also permits the capitalization of variable and fixed overheads, as long as the fixed overheads are assigned in a systematic and consistent manner and in relation to normal production levels.
When production is lower than projected, the resulting excessive overhead should be treated as a cost rather than a capital expenditure; nevertheless, when output is unusually high, the fixed overhead given to each unit must be reduced in order to avoid overvaluing inventories.
When several products are created from a same process, such as a primary product and a by-product, and the expenses are not clearly separated, the costs should be distributed “on a reasonable and consistent basis,”[1], such as based on the market worth of each unit after the two products are separated.
The capitalization is not permitted under IAS 2 Inventories
(a) the expense of waste levels that are abnormally high.
(b) storage expenses when storage is not required as part of the manufacturing process
(c) expenditures of administration
(d) the expense of selling
IAS 2 Inventories does not apply to the valuation of work in progress on building and service contracts (IFRS 15 does); similarly, IAS 32 and IFRS 9 apply to financial instruments, and IAS 41 applies to biological assets emerging from agricultural activities instead of IAS 2.
[2] Consult “IAS 23 Borrowing Costs” for information on capitalising borrowing costs in inventory.
The standard approach and the retail technique are two costing strategies allowed by IAS 2 Inventories. The standard method calls for inventory to be valued at the standard cost of each unit, or the ordinary cost per unit at normal production and efficiency. The inventory is valued under the retail method by calculating its sales value and subtracting the corresponding gross profit margin. When inventory items aren’t normally interchangeable, or when special products are designated for certain projects, their respective costs must be determined and given to them separately.
IAS 2 Inventories also mandates the use of the First-in, First-out (FIFO) principle, which states that products that have been in stock the longest are regarded to be consumed first, ensuring that items retained in inventory at the reporting date are valued at the most recent price. Alternatively, the weighted average cost formula may be used to allocate inventory costs.
The lower of cost or net realisable value must be used to record the worth of inventory. When the net realisable value of inventory falls below the cost of inventory, the loss must be recorded as an expenditure in the period in which the value lowers.