PAS 2

INVENTORIES

Introduction

PAS 2 prescribes the accounting treatment for inventories. PAS 2 recognizes that a primary issue in the
accounting for inventories is the determination of cost to be recognized as asset and carried forward
until it is expensed. Accordingly, PAS 2 provides guidance in the determination of cost of inventories,
including the use of cost formulas, and the subsequent measurement and recognition as expense.

PAS 2 applies to all inventories except for the following:

 Assets accounted for under other standards

a. Financial instruments (PAS 32 and PFRS 9); and

b. Biological assets and agricultural produce at the point of harvest (PAS 41).

 Assets not measured under the lower of cost or net realizable value (NRV) under PAS 2

a. Inventories of producers of agricultural, forest, and mineral products measured

at net realizable value in accordance with well-established practices in those
industries.

b. Inventories of commodity broker-traders measured at fair value less costs to

sell.

Inventories

Inventories are as assets:

a. Held for sale in the ordinary course of business (finished goods);

b. In the process of production for such sale (work in process); or

c. In the form of materials or supplies to be consumed in the production process or in the

rendering of services (raw materials and manufacturing supplies). (PAS 2.6)

Examples of inventories:

a. Merchandise purchased by a trading entity and held for resale.

b. Land and other property held for sale in the ordinary course of business.

c. Finished goods, goods undergoing production, and raw materials and supplies awaiting use in
the production process by a manufacturing entity.

Ordinary course of business refers to the necessary, normal or usual business activities of an entity.
Measurement

Inventories are measured at the lower of cost and net realizable value.

Cost

The cost of inventories comprises the following:

a. Purchase cost – this includes the purchase price (net of trade discounts and other rebates),
import duties, non-refundable or non-recoverable purchase taxes, and transport, handling and
other costs directly attributable to the acquisition of the inventory.

b. Conversion costs – these refer to the costs necessary in converting raw materials into finished
goods. Conversion costs include the costs of direct labor and production overhead.

c. Other costs necessary in bringing the inventories to their present location and condition.

The following are excluded from the cost of inventories and are expensed in the period in which they
are incurred:

a. Abnormal amounts of wasted materials, labor or other production costs;

b. Storage costs, unless those costs are necessary in the production process before a further
production stage (e.g., the storage costs of partly finished goods may be capitalized as cost of
inventory, but the storage costs of completed goods are expensed);

c. Administrative overheads that do not contribute to bringing inventories to their present location
and condition; and

d. Selling costs. (PAS 2.16)

When a purchase transaction effectively contains a financing element, such as when payment of the
purchase price is deferred, the difference between the purchase price for normal credit terms and the
amount paid is recognized as interest expense over the period of the financing.

Illustration:

Entity A acquires inventories and incurs the following costs:

Purchase price, gross of trade discounts 100,000

Trade discount 20,000

Non-refundable purchase tax, not included

in the purchase price above 5,000

Freight-in (transportation costs) 15,000

 Commission to broker 2,000

Advertisement costs 10,000

Requirement: How much is the cost of the inventories purchase?

Solution:

Purchase price, gross of trade discount 100,000

Trade discount (20,000)

Non-refundable purchase tax 5,000

Freight-in (transportation costs) 15,000

Commission to broker 2,000

Total cost of inventories 102,000

The advertisement costs are selling costs. These are expensed in the period in which they are incurred.

Cost Formulas

The cost formulas deal with the computation of cost of inventories that are charged as expense when
the related revenue is recognized (i.e., ‘cost of sales’ or ‘cost of goods sold’) as well as the cost of unsold
inventories at the end of the period that are recognized as asset (i.e., ‘ending inventory’). PAS 2 provides
the following cost formulas:

1. Specific Identification – this shall be used for inventories that are not ordinarily interchangeable
(i.e., those that are individually unique) and those that are segregated for specific projects.

Under this formula, specific costs are attributed to identified items of inventory. Accordingly, cost of
sales represents the actual costs of the specific items sold while ending inventory represents the actual
costs of the specific items on hand.

For example, if an inventory with a serial number of “ABC-123” costing P10,948.67 is sold, the amount
charged to cost of sales is also P10,948.67. if that inventory remains unsold the amount included in
ending inventory is also P10,948.67.

2. First-In, First-Out (FIFO) – under this formula, it is assumed that inventories that were
purchased or produced first are sold first, and therefore unsold inventories at the end of the
period are those most recently purchased or produced.

3. Weighted Average – under this formula, cost of sales and ending inventory are determined
based on the weighted average cost of beginning inventory and all inventories purchased or
produced during the period. The average may be calculated on a periodic basis, or as each
additional purchase is made, depending upon the circumstances of the entity.
The cost formulas refer to “cost flow assumptions”, meaning they pertain to the flow of costs (i.e., from
inventory to cost of sales) and not necessarily to the actual physical flow of inventories. Thus, the FIFO
or Weighted Average can be used regardless of which item of inventory is physically sold first.

Same cost formula shall be used for all inventories with similar nature and use. Different cost formulas
may be used for inventories with different nature or use. However, a difference in geographical location
of inventories, by itself, is not sufficient to justify the use of different cost formulas.

PAS 2 does not permit the use of a Last-In, First-Out (LIFO) cost formula.

Illustration:

Entity A, a trading entity, buys and sells Product A. Movements in the inventory of Product A during the
period are as follows:

Case 1: FIFO

Compute for the ending inventory and cost of sales using the FIFO cost formula

Step 1: Compute for ending inventory in units.

Step 2: Compute for ending inventory at cost.

Step 3: Compute for cost of sales.

Case 2.1: Weighted Average

Compute for the ending inventory and cost of sales using the Weighted Average cost formula. The
average is calculated on a periodic basis.

Step 1: Compute for the total goods available for sale in units and at cost.

Step 2: Compute for the weighted average unit cost.

Weighted average unit cost = P 7,400 / 600 = P 12.33

Step 3: Compute for ending inventory at cost.

Ending inventory (in units) – see computation in Case 1 280

Weighted average unit cost P 12.33

Ending inventory (at cost) P 3,452.40

Step 4: Compute for the cost of sales.

Total goods available for sale (at cost) P 7,400.00

Less: Ending inventory (at cost) (3,452.40)

Cost of sales P 3,947.60

Case 2.2: Weighted Average

Compute for the ending inventory and cost of sales using the Weighted Average cost formula. The
average is calculated as each additional purchase is made (also called the ‘moving average’).

*Moving ave. cost = TGAS at cost / TGAS in units

= (P4,600 / 400) = P 11.50

Cost of sales = 320 units sold x P11.50 moving ave. cost = P3,680

Net Realizable Value (NRV)

Net realizable 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”. (PAS 2.6)

NRV is different from fair value. “Net realizable value refers to the net amount that an entity expects to
realize from the sale of inventory in the ordinary course of business. Fair value reflects the price at
which an orderly transaction to sell the same inventory in the principal (or most advantageous) market
for that inventory would take place between market participants at the measurement date. The former
is an entity-specific value; the latter is not. Net realizable value for inventories may not equal fair value
less costs to sell.

Measuring inventories at the lower of cost and NRV is in line with the basic accounting concept that an
asset shall not be carried at an amount that exceeds its recoverable amount.

The cost of an inventory may exceed its recoverable amount if, for example, the inventory is damaged,
becomes obsolete, prices have declined, or the estimated costs to complete or to sell the inventory have
increased. In these circumstances, the cost of the inventory is written-down to NRV. The amount of
write-down is recognized as expense.

If the NRV subsequently increases, the previous write-down is reversed. However, the amount of
reversal shall not exceed the original write-down. This is so that the new carrying amount is the lower of
the cost and the revised NRV.

Write-downs of inventories are usually carried out on item by item basis, although in some
circumstances, it may be appropriate to group similar items.

Raw materials inventory is not written down below cost if the finished goods in which they will be
incorporated are expected to be sold at or above cost. If, however, this is not the case, the raw materials
are written down to their NRV.

Illustration:
Information on Entity A’s inventories are as follows:

Product A Product B

Cost 100,000 200,000

Estimated selling price 140,000 220,000

Estimated costs to sell 20,000 30,000

Requirement: Compute for the valuation of Products A and B in Entity A’s statement of financial
position.

Solution:

Lower 100,000 190,000

Amount of write-down - 10,000

Analysis:

 Product A need not be written-down because its cost is lower than its NRV.

 Product B shall be written-down by P10,000 because its cost exceeds its NRV (200,000 cost less
190,000 NRV).

 The total inventory to be shown in the statement of financial position is P290,000 (100,000 for
Product A + 190,000 for Product B).

 The P10,000 write-down is recognized as expense in profit or loss.

 Continuation:

Assume that in a subsequent period, the NRV of Product B increases as follows:

Product B

Cost 80,000

Net realizable value 100,000

Analysis:

 The increase is P20,000 (100,000-80,000). However, the amount of reversal that Entity A can
recognize is limited to P10,000, i.e., the amount of the original write-down.

 The amount of inventory to be show in the statement of financial position is P90,000 (80,000
cost + 10,000 reversal
Recognition as an expense

The carrying amount of an inventory that is sold is charged as expense (i.e., cost of sales) in the period in
which the related revenue is recognized. Likewise, the write-down of inventories to NRV and all losses of
inventories are recognized as expense in the period the write-down or loss occurs.

“The amount of any reversal of any write-down of inventories, arising from an increase in net realizable
value, shall be recognized as a reduction in the amount of inventories recognized as an expense in the
period in which the reversal occurs.”(PAS 2.34)

Inventories that are used in the construction of another asset is not expensed but rather capitalized as
cost of the constructed asset. For example, some inventories may be used in constructing a building. The
cost of those inventories is capitalized as cost of the building and will be included in the depreciation of
that building.

Disclosures

a. Accounting policies adopted in measuring inventories, including the cost formula used;

b. Total carrying amount of inventories and the carrying amount in classifications appropriate to
the entity;

c. Carrying amount of inventories carried at fair value less costs to sell;

d. Amount of inventories recognized as an expense during the period;

e. Amount of any write-down of inventories recognized as an expense in the period;

f. Amount of reversal of write-down that is recognized as a reduction in the amount of inventories

recognized as expense in the period;

g. Circumstances or events that led to the reversal of a write-down of inventories; and

h. Carrying amount of inventories pledged as security for liabilities. (PAS 2.36)