Inventory is one of the assets in the statement of financial position. In order to present it in the face of the financial statements, we need to determine its value in accordance with relevant standard. IAS 2 states that the inventory should be valued or calculated at the lower of cost and net realizable value. This calculation shall be done for each separate item or group of item. So how to value inventory in accordance with IAS 2?
In order to understand further, below is the basic rule of inventory valuation:
- Inventories might be valued at their expected selling price. In practice, it is impracticable to value the inventory at expected selling price. This involve of lot of judgments as well as assumption especially when such inventory is subject to seasonal changes.
- Inventories might be valued at their expected selling price, less any costs still to be incurred in getting them ready for sale and then selling them. This amount is referred to as the net realizable value (NRV) of the inventories. Valuing inventory at NRV is contradicted with the accounting concept of prudence.
For example, an item purchased for $100 requires $5 of further expenditure in getting it ready for sale and then selling it (eg $5 of processing costs and distribution costs). If its expected selling price is $140, its NRV is $(140 – 5) = $135. To value it at $135 in the statement of financial position would still be to anticipate a $35 profit.
- Inventories might be valued at their historical cost (the cost at which they were originally bought). This valuation method is always used for most of companies. However, in some exceptional cases, the historical cost cannot be applied especially when the prudence concept requires a lower value to be used.
- Inventories might be valued at the amount it would cost to replace them. This amount is referred to as the current replacement cost of inventories. This valuation method is rarely used. This requires obtaining the current selling price of similar product or inventory. This also involves some judgments as the current selling price from one company to another is difference.
In accordance with IAS 2, inventory shall value at lower of cost and net realizable value. This means shall value inventory at whatever it is lower either at cost or NRV. Below is the example of valuing the inventory to be in line with IAS 2:
|Inventory item||Cost $||NRV $||Lower of Cost/NRV $|
From the table above, the total inventory should be presented in the statement of financial position is $60.
However, it is impracticable to identify the lower of cost and NRV for each individual item for a company where it has a large amounts of inventory. In this case, it is acceptable to group similar item of inventories into categories and perform the comparison of the lower of cost and NRV of each category.
In conclusion, even though we have several method of valuing the inventory, only the lower of cost and NRV is permitted by IAS 2.