International Accounting Standard 2
The criteria to record and recognize the inventory is also explained as instructed under International Accounting Standard 2. Inventory is separated from the Non-Current Assets like plant and equipment which are held for sale at maturity and a further categorization of inventory is given in two forms like By-Products and Main products. The item which is normally sold out by the companies through ordinary course of its activities are termed as Inventory. Generally three forms of inventory are founded in any manufacturing companies which are Finished Products, Raw Material and Work-In-Process. All three inventories have different cost classifications and nature and should be measure on separate basis. There are four cost formulas to measure the inventory and are generally practiced in the US. Four formulas are LIFO, FIFO, Weighted Average Method and Specific Identification. This also explains the concept at which the reporting cost of the inventory is provided and Inventory should be reported at lower of Cost or Net Realizable Value (NRV). Cost is the value at which the inventory is purchased including purchase cost, carriage inwards and other taxes paid on the purchase whereas the Net Realizable Value id the amount at which the inventory can be sold out in the market less any expected expenses to complete the sale process.
International Accounting Standard 2 is one of the Accounting Standards issued by the Accounting Standard Committee to record and measure the financial items pertaining financial features. International Accounting Standard 2 encompasses the recording and measurement of Inventory. Inventory is defined in the International Accounting Standard 2 as “Assets which are held for sale in the ordinary course of activity by the company and it comprises Finished Products, Raw Materials and Work-in-Process. Inventories are the goods manufactured by the company in order to obtain the economic benefits from the sale to the customers. The main objective of the issuance of this standard is to separate the Non-Current Assets of the company from the inventory which is a Current Asset. Prior to the interpretation of International Accounting Standard 2, most of the companies have faced problems in the identification and recognition of the inventory and commonly the estimation and recording of the cost of inventory was a key concern for them. International Accounting Standard 2 has led the management to maintain and report the inventory at the reasonable and appropriate value. International Accounting Standard 2 defines the items of Inventory along with the methods to record the inventory. The methods which are being interpreted under International Accounting Standard 2 are FIFO, AVCO and LIFO. First in First Out (FIFO) is the method which explains that the oldest inventory should be sold out first and then the next one whereas the Weighted Average Cost Method (AVCO) means the inventory should be recorded by calculating the average cost of available inventory and then multiply this with the number of units in stock. Last in First Out (LIFO) is a method which is not being used currently because of some drawbacks attached to it as it promotes the system to sale the most recent purchases to be sold out prior to sale the old inventory. This Standard provides detail of each and every feature associated to the inventory and how to deal with that.
Due to the misappropriation of inventory there was a need to guide the companies as to record the inventories properly. This is why the International Accounting Standard 2 was issued and interpreted in a detailed way. If the company is involved in the sale and purchase of something then it is likely to hold inventory which can be in the form of Raw Materials, Finished goods and Work-in-process. Theoretically everything which is held for sale is termed as inventory but the question rises that either the plant and machinery held for sale are also termed as inventory then the answer would be ‘No’. Everything which is sold out through ordinary course of business is termed as sales and purchases eventually known as inventory. So the Non-Current Assets are not classified as Inventory under IAS 2. There are further 3 techniques are issued under this standard to record the inventory and inventory handling. First in First out (FIFO) is a method which tends to sale the oldest unit of inventory first and it makes sense as it would reduce the threat of inventory obsolescence. Weighted Average Cost Method (AVCO) is method which uses an average cost for all the units of inventory and records the inventory on this basis so there is no separation of recent and old purchases. Last in First out (LIFO) method promotes the sale of most recent purchases and there are more chances of obsolescence of inventory. Apart from these techniques the cost recognition criteria is also listed in this standard. As per International Accounting Standard 2, inventory should be recognized at lower of Cost or Net Realizable Value (NRV). Net Realizable Value is the value at which the inventory can be sold in the market or simple the market value. Theoretically this is the fair value concept and more appropriate to record the assets as it would lead to a fair appropriation of the assets of the company and no chance of being misled.
International Accounting Standard 2 defines the criteria to record inventory “Inventory should be recorded at lower of Cost or Net Realizable value (NRV). Cost is the amount at which the Inventory is being purchased initially and whereas the NRV is the amount at which inventory can be sold out. Net Realizable Value is the amount of cost less any expenses required to make inventory into a saleable state. Though there are some problems in the recognition of inventory because there are three types of inventories in a company which are subject to value at the most appropriate amount before recognition. Finished goods are required to be valued so that it can be recorded at lower of NRV or Cost as they do not require any further assessment criteria but Work-in-Process requires some extra work to make an appropriate valuation of inventory. There is a need to consider that how much material has been incurred to the product till that date and how many labor hours has been spent on the product. There is also a further calculation of overheads cost as to how much overheads should be allocated to the Work-in-process units as they are not yet completed so there is a need to calculate the amount of overheads. Generally the overheads are absorbed by the companies by using labor hours but mostly companies also use the machine hours as the absorption base. So this can ease the calculation of overheads allocation just simply cost of labor per hour multiply by the number of labor hours or machine hours incurred to the product. Generally the wastage costs, idle labor hours, storage costs and other costs like these are also included in the product cost. In most of the production processed two type of products are produced in a single process and are named as Main product and By-Product. By-products are the products which are produced unintentionally as these are not the ordinary items of the company for sale purposes but these should also be recorded as inventory because the economic benefits are expected to flow to entity from the sale of these products and the cost of such products can be measured at the joint process phase of production.
After the recognition of per unit cost, there are some formulas for the inventory valuation generally practiced in the US. LIFO, FIFO, Weighted Average Method and Specific Identification. Under IFRS and US GAAP all these formulas are same but the practice of some formulas are limited across the world due to the drawbacks attached to them and these methods are LIFO and Specific Identification. Main drawbacks to LIFO are much more in general as it promotes the threat of Inventory obsolescence and more risk in the incorrect valuation of the inventory. Due to this reason LIFO is discouraged across the world and now Weighted Average Method and FIFO are used extensively. In the past most of companies used the LIFO as their tax shields to reduce the profits and other manipulations but after the consideration of such issues the application of LIFO is now restricted and now limited to some states only.
There are some costs which cannot be the part of inventory in any case and they should be reported as an expense to the income statement. Most common examples of these costs are:
- Abnormal Wastage of material
- Abnormal Idle hours of Labor
- Abnormal overheads due to the Abnormal Idle Hours
- Reduction in the Net Realizable value of the inventory
- There are some handling costs which are not important for the product but incurred and these should not be measured in the inventory cost as well
- Admin expenses and other costs associated to admin department
This research provided a complete detail of the International Accounting Standard 2. The complete criteria and detail of the inventory recognition and measurement criteria is explained in this assignment. The measurement of the inventory is based on the management’s perception but with the introduction of this standard, all the criteria and relevant aspects have cleared. Management is guided thoroughly on the measurement of inventory and the recognition of the inventory instruments as to remove the ambiguity between the inventory and other assets of the company. Management has four different formulas to record the cost of the inventory and the most practical and generally accepted formulas are the FIFO and weighted average method. Management should use the cost formula among both of these as these are the recommended and practically accepted under IFRS and US GAAP. There would not be any problem in the inventory measurement if these rules are followed. Management is required to differentiate the By-products and Main products as both of these have different characteristics and benefits and need to be separately identified. The relevant cost should be ascertained to the inventory whilst the other should be charged to the expenses like abnormal wastage and labor cost etc.