Chapter 6: Inventory

Chapter 6: Inventory

Perspective and Issues

The accounting for inventories is a major consideration for many entities because of its significance on both the income statement (cost of goods sold) and the balance sheet. Inventories are defined by IAS 2 as items that are

  • ...held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.

The complexity of accounting for inventories arises from several factors.

  1. The high volume of activity (or turnover) in the account

  2. The various cost flow alternatives that are acceptable

  3. The classification of inventories

There are two types of entities for which we must consider the accounting for inventories. The merchandising entity (generally, a retailer or wholesaler) has a single inventory account that is usually titled merchandise inventory. These are the goods on hand that are purchased for resale. The other type of entity is the manufacturer. The manufacturer generally has three types of inventory: (1) raw materials, (2) work in process, and (3) finished goods. Raw materials inventory represents the goods purchased that will act as inputs in the production process leading to the finished product. Work in process (WIP) consists of the goods entered into production but not yet completed. Finished goods inventory is the completed product that is on hand awaiting sale.

In the case of either type of entity we are concerned with satisfying the same basic questions.

  1. At what point in time should the items be included in inventory (ownership)?

  2. What costs incurred should be included in the valuation of inventories?

  3. What cost flow assumption should be used?

  4. At what value should inventories be reported (net realizable value)?

The promulgated international standard that addresses these questions is IAS 2. This standard discusses the definition, valuation, and classification of inventory. The extant standard is a modest revision of an earlier standard; the principal difference is that the base stock method formerly permitted is now prohibited. International standards are somewhat less detailed than national standards issued by certain jurisdictions, and for that reason the requirements of IAS 2 are supplemented with guidance from other sources, where pertinent.

Under the provisions of IAS 2, the first-in, first-out, and weighted-average cost methods are defined as benchmark treatments, with the last-in, first-out method cast as the allowable alternative treatment. Since the international standards went to some length to avoid naming certain methods as being preferred or recommended (hence the term "benchmark," which was deemed to be more neutral), it is fair to consider all three methods as being acceptable under the IAS. An interpretation (SIC 1) by the Standing Interpretations Committee (SIC) of the IASC states that entities should use the same cost formula for all inventories having similar nature and use. It furthermore states that differences in geographic location would not, ipso facto, justify the use of different cost formulas. In reaching this conclusion, the SIC analogized from the guidance on consolidations provided in IAS 27, and that on property, plant, and equipment assets in IAS 16.

IASB, as part of the Improvements Project, has determined that the goals of achieving convergence among accounting standards and of promoting uniformity across entities reporting under IAS will be served by eliminating the current allowed alternative method of costing inventories by the last-in, first-out method. If adopted, this will leave the first-in, first-out and the average costing methods as the two acceptable costing techniques under IAS (now IFRS).

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Sources of IAS

IAS 2, 34


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