Last reviewed: July 2026.
IAS 2 Inventories explains how inventory cost is determined, which costs are recognised as an asset, when inventory becomes an expense and when a write-down to net realisable value (NRV) is required. Inventories are measured at the lower of cost and NRV so that they are not carried above the amount expected to be recovered through sale.
This page is the broad IAS 2 framework. For the practical journal flow, stocktaking, cut-off testing, NRV worksheet and period-end reconciliation process, use the inventory accounting workflow and NRV guide.
What qualifies as inventory
Inventory commonly includes goods held for sale, work in progress, finished goods, raw materials and supplies consumed in production or service delivery. Classification depends on the asset’s nature and intended use, not merely the label used in a warehouse or accounting system.
Some items require separate analysis. Major spare parts may be property, plant and equipment rather than inventory; property held for sale may fall under another Standard; and contract-related costs may need consideration under the applicable revenue requirements.
Core measurement rule
Inventory carrying amount = Lower of cost and net realisable value
The comparison is made using reliable quantity records, an appropriate cost formula and current evidence about selling prices, completion costs, condition and obsolescence.
Costs of purchase
Purchase costs normally include:
- purchase price;
- import duties and non-refundable taxes;
- transport, handling and other directly attributable acquisition costs;
- less trade discounts, rebates and similar reductions.
When payment terms contain a significant financing element, the financing component may need to be separated rather than included entirely in inventory cost.
Costs of conversion
Conversion costs include directly related production costs and a systematic allocation of fixed and variable production overhead. Fixed production overhead is allocated using normal production capacity. Unusually low production should not inflate inventory cost by assigning excessive fixed overhead to each unit.
Variable production overhead is allocated based on actual use of production facilities. Joint products and by-products may require a rational and consistent allocation basis.
Other costs and exclusions
Other expenditure is included only when it is incurred in bringing inventory to its present location and condition.
| Cost item | Typical treatment | Reason |
|---|---|---|
| Direct materials and labour | Include | Directly involved in purchase or conversion. |
| Normal production overhead | Include systematically | Brings production inventory to its present condition. |
| Abnormal waste | Expense | Does not represent normal inventory cost. |
| Storage | Usually expense | Included only when necessary before a further production stage. |
| Unrelated administration | Expense | Does not bring inventory to its present location and condition. |
| Selling costs | Expense | Relate to selling rather than producing or acquiring inventory. |
Cost formulas
The cost formula must match the nature and use of the inventory.
- Specific identification: used for items that are not ordinarily interchangeable or are produced for specific projects.
- FIFO: assigns the earliest costs to units sold, so closing inventory generally reflects more recent costs.
- Weighted average: assigns an average cost to similar interchangeable items.
IAS 2 does not permit LIFO. The same formula should be used for inventories with a similar nature and use unless a different formula is justified.
Standard cost and retail methods
Techniques such as standard cost or the retail method may be used when they approximate actual cost. Standards should reflect normal levels of materials, labour, efficiency and capacity and should be reviewed regularly. Significant variances require investigation and appropriate adjustment.
Net realisable value
NRV = Estimated selling price − Estimated completion costs − Costs necessary to make the sale
NRV is entity-specific and differs from fair value. Evidence may include recent sales, customer contracts, damage, expiry, obsolescence, product margins, later events confirming year-end conditions and costs still required to complete and sell the item.
Level of NRV assessment
NRV is normally assessed item by item. Grouping may be appropriate for similar or related items with a common purpose or end use when separate assessment is not practical. Broad write-downs across an entire classification should not conceal recoverable items.
Worked lower-of-cost-and-NRV example
An item costs 120 CU. Its expected selling price is 135 CU, completion costs are 8 CU and costs necessary to make the sale are 12 CU.
- NRV = 135 − 8 − 12 = 115 CU
- Cost = 120 CU
- Carrying amount = 115 CU
- Write-down = 5 CU
The write-down is recognised as an expense in the period.
Write-downs and reversals
A write-down is recognised when NRV falls below cost. If the circumstances causing the reduction later improve, the write-down is reversed only up to the amount originally recognised. The revised carrying amount cannot exceed the lower of original cost and revised NRV.
Both write-downs and reversals should be supported by item-level or appropriately grouped evidence, approval and a clear audit trail.
When inventory becomes an expense
When inventory is sold, its carrying amount is recognised as an expense in the period in which the related revenue is recognised. Inventory losses and write-downs are expensed when they occur. A perpetual or periodic system changes the journal workflow, but not the underlying IAS 2 measurement principles.
Work in progress and production controls
Manufacturing work in progress includes qualifying materials, labour and overhead incurred to the reporting date. Records should distinguish normal production from abnormal waste and identify items that are damaged, obsolete or no longer expected to generate recoverable proceeds.
Contract and service-related work in progress may require analysis under both IAS 2 and the applicable revenue requirements. Costs should not remain in inventory merely to defer an expense when they do not create or enhance a recoverable resource.
Presentation and disclosures
Disclosures commonly include:
- the accounting policy used to measure inventories;
- the cost formulas applied;
- carrying amounts by appropriate classification;
- inventory recognised as an expense;
- write-downs and reversals;
- circumstances leading to material reversals;
- inventory pledged as security where applicable.
Control framework
- authorise purchasing, receiving, production and inventory adjustments;
- restrict changes to item masters, standard costs and cost formulas;
- perform physical counts and reconcile them to perpetual records;
- test purchase, production and sales cut-off;
- review negative quantities, unusual margins and slow-moving inventory;
- document ownership of goods in transit, consignment goods and third-party stock;
- reconcile inventory subledgers to the general ledger.
Common mistakes
- including abnormal waste or selling expenditure in cost;
- allocating fixed overhead using abnormally low production;
- using selling price without deducting completion and selling costs;
- applying LIFO under IAS 2;
- ignoring obsolete, damaged or expired items;
- using unsupported percentage provisions;
- failing to reverse a write-down when the supporting conditions improve;
- counting goods in transit or consignment stock incorrectly;
- poor purchase and sales cut-off.
Related Accounting Support guides
- Inventory accounting workflow, journals and NRV worksheet
- Inventory valuation methods
- Stocktaking procedures
- Trial balance and financial statement process
Authoritative references
Key takeaway
IAS 2 combines disciplined cost accumulation with a recoverability test. Include only qualifying costs, apply a consistent cost formula, compare carrying amount with realistic NRV evidence and recognise write-downs or reversals in the correct period. Reliable quantity records, cut-off and reconciliation are essential to support the valuation.