Inventory valuation determines the amount reported as inventory and the expense recognised as cost of sales. IAS 2 requires inventories to be measured at the lower of cost and net realisable value and specifies how cost is assigned to items.
Correct valuation affects gross profit, current assets, working capital and tax calculations. Overstated closing inventory overstates profit and assets; understated inventory has the opposite effect.
What Qualifies as Inventory?
Inventories include assets held for sale in the ordinary course of business, assets in the process of production for sale and materials or supplies consumed in production or service delivery.
Lower of Cost and Net Realisable Value
Inventory carrying amount = Lower of Cost and NRV
Net realisable value is the estimated selling price in the ordinary course of business less estimated completion costs and costs necessary to make the sale. NRV is entity-specific and differs from fair value.
Components of Inventory Cost
| Cost category | Included examples | Excluded examples |
|---|---|---|
| Purchase cost | Purchase price, non-recoverable taxes, import duties, freight and handling, less trade discounts. | Recoverable VAT or similar taxes. |
| Conversion cost | Direct labour and systematic allocation of fixed and variable production overhead. | Abnormal idle capacity or abnormal waste. |
| Other cost | Costs necessary to bring inventory to its present location and condition. | Selling costs, most storage costs and general administration not contributing to production. |
Fixed Production Overhead
Fixed production overhead is allocated based on normal capacity. When production is unusually low, unallocated overhead is expensed rather than increasing the cost of each unit. When production is abnormally high, the allocation per unit is reduced so inventory is not measured above cost.
Specific Identification
Specific identification is used for items that are not ordinarily interchangeable and for goods or services produced and segregated for specific projects. Examples include customised machinery, unique vehicles or individually identifiable property units.
FIFO Cost Formula
First-in, first-out assumes the earliest purchased or produced units are sold first. Closing inventory therefore reflects more recent costs. FIFO is a cost-flow assumption and does not require the physical movement of goods to match the accounting flow.
Weighted-Average Cost Formula
Weighted-average cost assigns the average cost of similar items. The average can be calculated periodically or after each shipment, depending on the system. The same cost formula is used for inventories with similar nature and use.
Why LIFO Is Not Used under IAS 2
IAS 2 permits FIFO and weighted average for ordinarily interchangeable items but does not permit last-in, first-out. A business applying IFRS should not use LIFO for financial reporting.
Worked FIFO and Weighted-Average Example
| Transaction | Units | Unit cost |
|---|---|---|
| Opening inventory | 100 | $10 |
| Purchase 1 | 120 | $12 |
| Purchase 2 | 80 | $15 |
| Units sold | 220 | — |
Total units available are 300 and total cost is $3,640. Closing inventory contains 80 units.
FIFO: the 80 closing units come from the latest purchase at $15, so closing inventory is $1,200 and cost of sales is $2,440.
Weighted average: average cost is $3,640 ÷ 300 = $12.1333. Closing inventory is approximately $970.67 and cost of sales is approximately $2,669.33.
Net Realisable Value Example
An item costs $90. Its expected selling price is $105, completion cost is $12 and selling cost is $8. NRV is $85. The inventory is written down from $90 to $85, creating a $5 expense.
Write-Downs and Reversals
Inventory is written down when damaged, obsolete, slow-moving or expected to sell below cost. If circumstances improve, a previous write-down is reversed, limited to the original write-down. The reversal reduces the inventory expense in the period.
By-Products and Joint Products
When conversion costs cannot be separately identified, they are allocated on a rational and consistent basis. Immaterial by-products may be measured at NRV, with that amount deducted from the cost of the main product.
Inventory Counts and Internal Control
Valuation depends on accurate quantities. Businesses use periodic or perpetual records, physical counts, cycle counts, cut-off testing, damaged-goods reviews and reconciliations. Consignment goods, goods in transit and returns require special attention.
Common Errors
- Valuing inventory at selling price without deducting completion and selling costs.
- Including abnormal waste and unrelated administration costs.
- Using recoverable taxes as part of inventory cost.
- Using LIFO under IFRS.
- Ignoring obsolete or damaged goods.
- Applying different formulas to inventories with similar nature and use without justification.
- Failing to include goods owned but held by another party.
Financial Statement Effect
| Error | Inventory | Cost of sales | Profit |
|---|---|---|---|
| Closing inventory overstated | Overstated | Understated | Overstated |
| Closing inventory understated | Understated | Overstated | Understated |
| Opening inventory overstated | No direct closing effect | Overstated | Understated |
Standard Cost and Retail Techniques
IAS 2 permits techniques such as standard cost or the retail method when the result approximates actual cost. Standard costs should reflect normal material, labour, efficiency and capacity levels and must be reviewed regularly. The retail method is often used for large volumes of rapidly changing items with similar margins; inventory cost is estimated by reducing selling value by the appropriate gross margin percentage.
These techniques are measurement shortcuts, not separate cost formulas. Management should test whether the approximation remains reliable, especially when purchase prices, markdowns, product mix or gross margins change significantly.
Frequently Asked Questions
What is the basic IAS 2 measurement rule?
Inventory is measured at the lower of cost and net realisable value.
What costs are included in inventory?
Purchase costs, conversion costs and other costs needed to bring inventory to its present location and condition.
Does IAS 2 allow LIFO?
No. FIFO and weighted average are permitted for ordinarily interchangeable items.
Can an inventory write-down be reversed?
Yes, when circumstances improve, but only up to the amount of the original write-down.
Is NRV the same as fair value?
No. NRV is entity-specific and based on the ordinary course of business; fair value is a market-based measurement.
Related Guides
- Accounting for Inventory Lost or Destroyed
- Trading and Profit and Loss Account
- Cost Accounting Basics
- Balance Sheet Explained
Conclusion
The most useful analysis combines correct calculations with context. A ratio, valuation, reconciliation or accounting treatment should be applied consistently, supported by evidence and interpreted with the entity’s facts, reporting framework and materiality in mind.
Authoritative references: IFRS Foundation — IAS 2 Inventories, IFRS Foundation — IAS 2 Supporting Material.