Measurement of Inventory

1 Introduction

The measurement of inventory can be extremely important for financial reporting, because the measurements affect both the cost of sales (and profit) and also total asset values in the statement of financial position. There are several aspects of inventory measurement to consider:

• Should the inventory be valued at cost, or might a different measurement be more appropriate?
• Which items of expense can be included in the cost of inventory?
• What measurement method should be used when it is not practicable to identify the actual cost of inventory?

IAS 2: gives guidance on each of these areas.

Measurement rule

IAS 2 requires that inventory must be measured in the financial statements at the lower of:

• cost, or
• net realisable value (NRV).

The standard gives guidance on the meaning of each of these terms.

2 Cost of inventories

IAS2 states that ‘the cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

Purchase cost

The purchase cost of inventory will consist of the following:

• the purchase price
• plus import duties and other non-recoverable taxes (but excluding recoverable sales tax)
• plus transport, handling and other costs directly attributable to the purchase (carriage inwards), if these costs are additional to the purchase price.

The purchase price excludes any settlement discounts, and is the cost after deduction of trade discount.

Example

Conversion costs

When materials purchased from suppliers are converted into another product in a manufacturing or assembly operation, there are also conversion costs to add to the purchase costs of the materials. Conversion costs must be included in the cost of finished goods and unfinished work in progress. Conversion costs consist of:

• costs directly related to units of production, such as costs of direct labour (i.e. the cost of the labour employed to perform the conversion work)
• fixed and variable production overheads, which must be allocated to costs of items produced and closing inventories. (Fixed production overheads must be allocated to costs of finished output and closing inventories on the basis of the normal production capacity in the period)
• other costs incurred in bringing the inventories to their present location and condition.

You may not have studied cost and management accounting yet but you need to be aware of some of the costs that are included in production overheads (also known as factory overheads). Production overheads include:

• costs of indirect labour, including the salaries of the factory manager and factory supervisors
• depreciation costs of non-current assets used in production
• costs of carriage inwards, if these are not included in the purchase costs of the materials Only production overheads are included in costs of finished goods inventories and work-in-progress. Administrative costs and selling and distribution costs must not be included in the cost of inventory.

Note that the process of allocating costs to units of production is usually called absorption. This is usually done by linking the total production overhead to some production variable, for example, time, wages, materials or simply the number of units expected to be made.

Example

Flow of information

Production overhead is recognised in an expense account in the usual way. Production overhead is then transferred from this account to an inventory account (perhaps via a work-in-progress account) as units are produced.

Illustration

The flow of information can be represented by the following diagram:

Illustration

Normal production capacity

Fixed production overheads must be absorbed based on normal production capacity even if this is not achieved in a period.

Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances. The actual level of production may be used if it approximates normal capacity. The amount of fixed overhead allocated to each unit of production is not increased if actual production capacity falls short of the normal capacity for any reason. Similarly, the amount of fixed overhead allocated to each unit of production is not decreased if actual production capacity is higher than the normal capacity for any

reason. Usually, the actual fixed production overhead recognised as part of the inventory cost differs from the actual fixed production overhead incurred. Any difference is recognised as an expense or a reduction of an expense (usually cost of sales).

• Under-absorption (fixed production overhead in inventory is less than fixed production overhead incurred) is a debit to cost of sales.



Illustration

• Over-absorption (fixed production overhead in inventory is greater than fixed production overhead incurred) is a credit to cost of sales.

 

This may seem a little pointless at first sight. After all the cost incurred of Rs. 1,000 is the same as the cost recognised in the statement of profit or loss (Rs. 750 + Rs. 250). However, the Rs. 250 in the statement of profit or loss is expensed. In other words, it is not part of the cost of inventory.

Example

The above example considers the situation where the fixed production incurred in the period is more than that absorbed (under-absorption). The opposite could also be true.

Example

3 Net realisable value

Definition

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 is the amount that can be obtained from selling the inventory in the normal course of business, less any further costs that will be incurred in getting it ready for sale or disposal.

• Net realisable value is usually higher than cost. Inventory is therefore usually valued at cost.
• However, when inventory loses value, perhaps because it has been damaged or is now obsolete, net realisable value will be lower than cost.

The cost and net realisable value should be compared for each separatelyidentifiable item of inventory, or group of similar inventories, rather than for inventory in total.

Example

Net realisable value might be lower than cost so that the cost of inventories may not be recoverable in the following circumstances:

• inventories are damaged;
• inventories have become wholly or partially obsolete; or,
• selling prices have declined.

4 Accounting for a write down

When the cost of an item of inventory is less than its net realisable value the cost must be written down to that amount.

Component A1 in the previous example was carried at a cost of Rs. 8,000 but its NRV was estimated to be Rs. 7,300.The item must be written down to this amount. How this is achieved depends on circumstance and the type of inventory accounting system.

Perpetual inventory systems

The situation here is similar to that for inventory loss.

The inventory must be written down in the system by the following journal:

Illustration:

                                     Debit Credit

Cost of sales                 X

Inventory                                    X

Period end system / Periodic inventory system

If the necessity for the write down is discovered during an accounting period then no special treatment is needed. The inventory is simply measured at the NRV when it is included in the year end financial statements. This automatically includes the write down in cost of sales.

If the problem is discovered after the financial statements have been drafted (and before they are finalised) the closing inventory must be adjusted as follows:

Illustration:

                                                                                  Debit Credit

Statement of comprehensive income closing

inventory (cost of sales)                                             X

Inventory in the statement of financial position                 X

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