International Accounting Standard 2 (IAS2) became effective on 1 January 1995, replacing the IAS issued in October 1975 and known as the evaluation and submission of inventory in the context of the historical cost. This was later revised by the International Accounting Standards Board (IASB) in 2003. This standard relates to the accounting treatment of inventories and guides in the determination of the inventory cost and the subsequent recognition of an expense that includes write-downs to the net realisable value. It also offers guidance on the cost formulas which are used in assigning costs to the inventories (Deloitte, 2010).
Underlying rationale and relation with IASB's framework
Under this standard, the inventories are measured at cost or net realisable value, whichever is lower. Net realisable value refers to the selling price that is estimated to be received during the course of activities after deducting for any estimated costs relating to completion and other such costs that are incurred in making the sale.
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The main objective of IASB for IAS2 was to reduce the alternatives in the measurement of inventories. The revised IAS2 does not allow exchange rate differences arising from the purchase of inventories that are invoiced in another currency to be treated as a part of the inventories purchase cost (Malaysian Accounting Standards Board, 2010).
Measurement, presentation and disclosure
As per IAS2, the inventories are measured at cost or realisable value, whichever is lower, based on every item. The inventory cost is the sum total of the purchase cost including cost price, import duties, handling as well as transportation costs; after any adjustments for rebates and trade discounts, conversion costs and other costs that are incurred in transporting the inventories to the current location and form. However, this excludes storage costs, and costs relating to abnormal wastage, selling and administration. Inventories costs can be approximated using either the standard cost method or retail inventory method.
The cost of inventories relating to items that are usually interchangeable, and also goods or services that are produced and set aside for other projects, can be assigned costs on the basis of specific identification. The inventories are valued using either the first-in-first-out (FIFO) method or the weighted average method. When FIFO is used, the items in the inventory are measured on the basis of recent purchases.
Net realisable value is the monetary amount that the business expects to receive from the sale of inventory in the due course of the business. In the balance sheet an entity reports the lower of the net realisable value and cost as an asset. This is shown below:
After the sale of inventories, the carrying amount of the related inventories is recognised as expenditure in the income statement in the time period when the revenue from it is recognised. In the event of a fall in the net realisable value below the inventories' costs the write-down is shown in the income statement of the relevant period in which it occurs. A rise in the net realisable value is shown as a reduction in the inventories amount that was shown as an expense in the time period of the reversal.
The disclosures include the following:
The accounting policies that are adopted in the measurement of the inventories and also includes the cost formula that is used.
Total carrying value of the inventories is classified as appropriate to the business entity.
The carrying value of the inventories is recorded at fair value minus costs relating to sale.
The amount of inventories that are consumed during the accounting period, disclosing any write-downs to the net realisable value separately.
Reversal of any write-down amount and the events or circumstances that led to it.
The carrying inventories amount that is pledged as a security for loans or any other liability.
Application and Scope
The IAS2 rules and procedures are applicable to all inventories with the exception of the following:
Work-in-progress that arises in the case of construction contracts.
Biological assets that are a part of agricultural activities and produce at the time of harvest.
The principles relating to IAS2 do not apply to inventories that are held by producers of forest and agricultural products; agricultural produce held after the harvest; minerals as well as mineral products to the point that they are valued at net realisable value as per the established practices prevailing in those industries. Nor will this apply to broker-traders of commodities who measure the amount of inventories at fair value minus costs related to sale (CPA Australia Ltd., 2008).
Comparison with US GAAP
Always on Time
Marked to Standard
There are three main differences in inventory valuation between IAS2 and US GAAP. Firstly, the last-in-first-out (LIFO) method of inventory valuation is not permitted under IFRS, mainly IAS2 but this is permitted under US GAAP. Secondly, the reversal of write-downs in inventory is allowed in IAS2 under certain conditions but this is not allowed in GAAP. Thirdly, while US GAAP considers the lower of cost or market value, IAS2 considers the lower of cost or net realisable value. Due to the above differences the amount of inventory in the balance sheet should, other things being equal, be greater under IAS2 provided the asset prices generally increase over time.
The prohibition of LIFO in IAS2 will make the process of inter-company comparison simpler as there will be no need to adjust the inventory values arrived at by alternative methods. The application of the LIFO method leads to a mismatch in the sales and costs. Under LIFO, the recent costs are shown in the income statement and the balance sheet values are based on old LIFO values. When there is a decrease in the actual inventory it can lead to LIFO liquidation and result in an extraordinary mismatch in the timing of sales and costs. This will further distort the differences between the two accounting forms.
As LIFO is not allowed under IAS 2, this will raise the value of the inventory in the balance sheet provided that the asset prices increase over time. However, during deflationary periods the inventory value will be higher in the balance sheets of companies that use US GAAP as compared to the companies using IAS2.
Due to the effect of inventory write-downs under IAS2 the value of inventory is higher in the balance sheet in the case of IAS2 when a significant decreasing trend in the price of the inventory is reversed.
IAS2 allows the recognition of the lower of cost or net realisable value and not the lower of cost or market value rule as followed by GAAP. The market value refers to replacement cost. Net realisable value is the ceiling of replacement cost and its floor is net realisable value minus a normal margin of profit. As the net realisable value forms the ceiling, the value of inventory reported under IAS2 is greater than or equal to the inventory amount under GAAP (Bao & Romeo, 2009).
Tesco Plc follows IFRS in presenting its accounting information (London Stock Exchange plc, 2009). In its annual reports for the year 2009, the company valued its inventories at cost and fair value minus the costs of sell using the weighted average method of costing (Tesco Plc, 2009, pp. 74).
IAS2 relates to the accounting treatment of the inventories. The inventories consist of the assets that are held for the purpose of sale in the due course of business. Recently the harmonisation of the international reporting standards has gained momentum. There exist important differences in the reporting standards under US GAAP and IFRS, mainly IAS2. The former considers LIFO as well as FIFO in the measurement of inventory whereas the use of LIFO is prohibited under IAS2. This leads to a rise in the inventory amount in the balance sheet under IFRS. Under the FIFO method of inventory valuation the calculations are based on the more recent purchases. This means that this method gives preference to the most recent prices prevailing in the market. Under the LIFO method of inventory valuation, the calculations are based on the prices of the inventories that first enter the system. The weighted average method, as the name itself suggests, considers the weighted average costs of the inventories.
A change in the inventory value affects the net income. As per IAS 2, the inventories are reported initially as an asset in the balance sheet and thereafter reported as an expenditure in the statement if income, this includes any write-downs in the net realisable value.