PAS 2: INVENTORIES

Objective:

➢ Prescribe the accounting treatment of INVENTORIES.

➢ Provide guidance for determining the cost of inventories
➢ Provide guidance for subsequently recognizing an expense (including any write down to
net realizable value)
➢ Provide guidance on the cost formulas that are used to assign cost to inventories.

Scope:

INVENTORIES
- Assets held for sale in the ordinary course of business. (Finished Goods)
- Assets in the production process for sale in the ordinary course of business. (Work in
Process)
- Materials and supplies that are consumed in the production/ rendering services. (Raw
Materials)

➢ All Inventories are governed by PAS 2, EXCEPT:

o Work in process arising under Construction Contracts.
o Financial Instruments held for sale.
o Biological Assets related to Agricultural Activity and Agricultural Produce at the
point of harvest.
▪ They are Inventories but they are governed by a different standard.

➢ Items of Inventory primarily held for sale/ within the scope of the standard but are
EXCLUDED from the measurement provisions of PAS 2 (by their very nature/ uses of
trade, they are measured at Net Realizable Value)
o An asset that can easily be sold at any point of the products life (Raw or
Processed). These are sold in a separate market where their practice in to
measure the items at Net Realizable Value.
o Commodities, items that are not processed further but are still sold because of
its volatility of its price due to intense activity in the market.
▪ Entities who sell these inventories for the purpose of the volatility in the
net realizable value of the assets. They expect to profit from the
regularly changing value of the assets and not from the mark up after
reselling/processing it.
Definitions:

Inventories – are always classified as Current Assets. (Check “Scope”)

Current assets – Assets expected to be used, utilized, consumed, and realized within 12
months/ normal operating cycle (amount of time it takes for the inventories to be produced,
sold, and collect receivables).
- Even if the Asset exceeds 12 months of realization or consumption, as long as it is
withing the Normal Operating Cycle, then it is still considered Current Asset.

MEASUREMENT OF INVENTORY

Net Realizable Value - the net value one can realized in buying, processing, and selling the
good.
- An entity specific value.

Estimated selling price in the ordinary course of business

(Less) Estimated cost to completion
(Less) Estimated Cost Necessary to make the Sale
▪ The two costs may be different between entities, e.g. Two entities may
have the same selling price for the same goods sold, but different in terms
of cost to completion.

Fair Value – is the price that would be received to sell an asset or paid in transferring a liability
in orderly transaction between market participants at the measurement date.
- Can be used in arriving to the Net Realizable Value.
- Equally applicable to every entity.

DIFFERENT KINDS OF INVENTORIES MAINTAINED BY DIFFERENT KINDS OF BUSINESSES

- These accounts are classified as Current Assets.

Business: Merchandising Business

Inventory Acc: Merchandise Inventory
- Buying and Selling (no Processing/ Improving)
- Selling the goods at the same state as buying them.

Business: Manufacturing Firms

Inventory Acc:
o Raw Materials Inventory (e.g. Supplies)
o Work in Process Inventory (Unfinished/ Raw Materials Subjected for Further
Processing)
o Finished Goods Inventory (Goods Ready for Sale)
- Using raw materials to make finished products for sale.
MEASUREMENTS OF INVENTORIES
➢ Inventories shall be measured at the lower between/ of cost and net realizable value.
- In choosing the carrying amount for the inventory (in the subsequent reporting
period), compare first the ORIGINAL COST OF THE ASSET and the NET
REALIZABLE VALUE at the date of the financial statements and CHOOSE THE
LOWER AMOUNT.

▪ This does not mean that the recognition of the INITIAL and SUBSEQUENT
measurement for Inventories is the same. For Inventories:
- INITIAL = at COST IN ACQUIRING THE ASSET (avoid recognizing
loss upon initial recognition, but not for some accounts, PAS 41)
- SUBSEQUENT = Lower between/ of COST & NET REALIZABLE
VALUE (LCNRV)
▪ If it is the Cost that is lower, then there is no problem
▪ If it is the Net Realizable Value, a loss in value in inventory will be
recognized. (Product/ Item is recognized as IMPAIRED)

Cost of Inventories/ Inventoriable Costs will comprise:

1. All Cost of Purchase – the price paid to the seller
2. Costs of Conversion (Relevant for Manufacturing Firm)
3. Other Costs incurred in bringing the inventories to their present location &
condition. (All Necessary Costs)

1.) Cost of Purchase

- Purchase Price
- Import Duties and Other Taxes (should not be recoverable)
- Transport
- Handling
- Additional Costs in acquiring the goods/ inventory/ Directly
Attributable Cost
- (Less) Trade Discounts
- (Less) Rebates
- (Less) Other Items Deducted from Determining the Cost.
 2.) Cost of Conversion / Product Cost:
- Direct Material
- Direct Labor
- Overhead (Any Form Related to the Manufacturing of the
Product)
o Fixed Prod. Overhead (Total) – fixed regardless of the
amount of units. (e.g., Rent)
• Diff. from Fixed Overhead per Unit, which
is: Total Fixed Overhead * No. of Units
• No. of Units Increases, FO/ Unit Decreases
o Variable Prod. Overhead – Depend on the amount of units
produced. (e.g., Electricy, Water)
• No. of Units Increases, VO/ Unit Increases

o Normal Capacity – Production expected to be achieved on average over a

number of periods/ seasons under normal circumstances taking into account the
Laws of normal capacity resulting from plan maintenance.
- To avoid undervaluing/ overvaluing the costs of inventories.

3.) Other Costs/ DAC/ All Necessary Cost

These are Costs EXCLUDED from the cost of inventories but reported as an
EXPENSE:
• Abnormal Amounts of Wasted Materials, Labor, or other
Production Costs
• Storage Costs unless they are necessary in the production process
• Administrative Overheads that do not contribute to the bringing
inventories to their present location (e.g. accounting managers)
• Selling cost (classified as Distribution Cost)

Cost Formulas
➢ Cost of the inventories remains an Asset until that inventories are sold, Cost of Goods
Sold (Statement of Comprehensive Income as an Expense).
➢ Unsold inventories are placed in the Ending Inventory at the making of financial
statements.

METHODS
o Specific Identification – a method ideally used for Low Quality – High Value
Inventories.
o First In, First Out (FIFO)
o Weighted Average Cost
INVENTORY WRITEDOWN – done when the NRV is lower than the COST.

Net Realizable Value (NRV) = Recoverable Amount of Inventories

➢ The cost of inventories may not be recoverable (Proceeds from selling is lower than the
cost) if those inventories;
o Are damaged
o become wholly or partially obsolete
o if their selling price declined.
- In this case, we will have to recognize a loss on inventory write-
down.

➢ Conservatism – avoid instances where the assets are not overstated. Not exceed the
recoverable amount (amount recovered if assets are sold/disposed)

ITEM BY ITEM APPLICATION

➢ Inventories (Goods/Products) are usually written down to net realizable value Item By
Item.
➢ Meaning: Apply the LCNRV to every Inventory Item.

REVERSAL ON INVENTORY WRITE-DOWN - Done when the NRV goes from lower than cost to
high/ increased in the subsequent year.

➢ Compare the Cost to the New NRV of the Item, and CHOOSE THE LOWER ONE.
➢ To Record: Increase inventories by the diff. of the Old NRV and New NRV. (Increase is
considered as a Gain on Reversal of Inventory Write-down)

Gain on Reversal
➢ There is a limit in Gain on Reversal.
➢ The accumulated GAIN on Reversal should not Exceed the Previously Recognized LOSS.

When (What Period) should the Cost of Inventories be reported in the Income Statement?
When should the Loss on Inventory Write-down be reported in the Income Statement?
When should the Gain on Reversal be reported?

• Always in THE PERIOD IN WHICH THEY OCCURRED

Disclosures
➢ Accounting Policies Adapted in Measuring & Cost Formula Used
➢ Etc.