6 SUCCINCT POINTS ON HOW TO ACCOUNT FOR INVENTORIES.

How to account for inventories (or stock, as it was formerly called) is covered by the principles of IAS 2, Inventories. In this short article, keeping with the principles of IAS 2, you shall be intimated with notable points on how to account for inventories in the financial

INVENTORIES OF ITEMS

statements. IAS 2, inventories covers the principles that guide how to account for various types of inventories with the exception of the following items:

1. ·          Work-in-progress on construction contract.
2. ·         Inventory of agricultural produce.
3. ·         Inventory of mineral resources such as crude oil and tin ore.

Point 1: Meaning of Inventories

Inventories are assets in the form of raw materials used for production, material work-in-progress, finished products held for sale and spares or goods consumed in the process of production or provision of services. Simply put, the materials and goods you hold for sale or for use in production and other uses are called inventories.

Point 2: What basis should you use to value inventories?

You should value inventories at the lower of the cost of the inventories and the net realizable value (NRV). Well, net realizable value (NRV) is the estimated amount that you can get from the sale of inventories less the estimated amount that you will incur to make the sale. So, if the net realizable value is less than the cost of the inventories, then, the net realizable value becomes the value of the inventories in the financial statements.

Please, equally note that the cost of inventories includes all the costs incurred on the purchase of the inventories as well as the amount spent to bring them to where they are used and the all the costs incurred to put the inventories into useful condition i.e. purchase cost, carriage or transport cost and processing cost.

Point 3: How is the cost of inventories determined?

Where substantial numbers of inventories are purchased gradually over a period of time at different prices (or costs) and later are either used in production or sold; how do you determine the value or cost to place on those ones used or sold?

For example, say you purchased on January 1, 2015 600 units of calculators at N500 each, and on January 5, 2015 you purchased another 500 units of calculators at N 600 each. But on January 20, 2015 you sold 800 units out of the lot. Then, how do we determine the cost of the 800 units sold? Should we use N 500 per unit or N 600, or the simple average of the two costs which is N 550?

The standard says that you should determine the cost of each unit of inventories sold or used using either first-in-first-out (FIFO) method or weighted average method. With FIFO, you assume that the first unit purchased are the first sold. So in the above example, the cost of the 800 units can be determined as follows:

Using First-In-First-Out method:

The first 600 units @ N 500               =  300,000.00

The remaining 200 units @ N 600      =  120,000.00

                                                       N 420,000.00

The assumption behind this method is that the first set of 600 units of calculators purchased were the first to be sold and therefore carried a cost per unit of N 500.While the remaining balance of 200 units were considered sold out of the 500 units purchased on January 5, 2015 at N 600 per unit.

Using Weighted Average method:

Weighted average cost = ( (N 500 X 600 units)+ ( N 600 X 500 units)

                                               (600 units+500 units)

                                        N 600,000.00       =  N 545.45

                                            1100 units

800 units @ N 545.45   = N 436,363.64

Point 4: How do you measure net realizable value (NRV)?

At every balance sheet date, net realizable value of inventories must be estimated (not guestimated!). If your finished goods inventories are being sold at a price which is above the cost of all the input of materials used to produce them, then their net realizable value will be estimated to be above the cost.

On the other hand, raw materials and goods which can be sold below the cost should be given a net realizable value that is equalled to the price at which they can be replaced. 

Point 5: What expenses should you recognize on inventories?

As you know, expenses are sometimes recognized on assets. For example, depreciation is recognized annually as an expense on property, plant and equipment. So, by extension, certain expenses are also recognized on inventories.

If inventories are sold and revenue from the sales recognized, expenses should also be recognized in the same period and related to the revenue. So, therefore, if your finished goods (i.e. inventories) are sold and revenue on them recorded or recognized; in the same vein an expense called cost of sale should also be recognized and recorded against this revenue in the same period.

Furthermore, where the cost of inventories is lower compared to their net realizable value (NRV), the cost of the inventories must be ‘written down’ to the net realizable value. The written down amount (i.e. the difference between the net realizable value and the cost) constitutes an expense charge in the financial statements.

Point 6: What are those things you must disclose with respect to inventories?

IAS 2, inventories, catalogued some aspects of your inventories which you should disclose or show in the financial statements. These are:

1. The policy you use for determining the cost of your inventories such as the FIFO or weighted average method.
2. The carrying amount of your inventories categorized into finished goods, work-in-progress, raw materials, spares, consumables and so on.
3. The amount of your inventories recognized as expense (i.e. cost of sale) in the current period.
4. The amount by which the cost of your inventories is written down to their net realizable value, which you charged as an expense in the financial statements.
5. The portion of your inventories that you pledged or use as collateral security.

Conclusion:

It does not take much to get a good grasp of how to account for inventory. All you need to know is that, at balance sheet date or year end; inventories are accounted for and valued based on the lower of their cost or net realizable value. This figure for inventories represents your closing inventories' figure which is used in determining your cost of sale and which is also disclosed in the statement of financial positions as a current asset.