3 Cost formulas
In order to simplify the cost measurement of inventories or precisely said to simplify cost assignment to inventories, entities can use cost formula. IAS 2 allows the use of First in First out (FIFO) and Weighted Average Cost method. LIFO is not permissible under IAS 2.
Entity can use cost formula like FIFO or Weighted Average to assign cost to the inventories if the goods are interchangeable. However, if entity holds such items in inventory in which each and every items is not interchangeable then for such inventory specific costs (actual costs or standard cost) are assigned and cost formula cannot be used on such inventory.
The entity should divide inventories into groups on the basis of the nature and use of inventory and then apply the same cost formula to such goods which are similar in use and nature. However for such group of inventories which have different nature and use a different cost formula can be used. But difference in nature and use does not mean difference in the location of the asset or tax treatment.
4 Net realisable value
4.1 What is NRV?
Net realisable value is the estimated selling price in the ordinary course of business less:
- the estimated costs of completion; and
- the estimated costs necessary to make the sale.
4.2 Difference between NRV and Fair Value
Net realisable value refers to the net amount that an entity expects to realise from the sale of inventory in the ordinary course of business.
Fair value reflects the amount for which the same inventory could be exchanged between knowledgeable and willing buyers and sellers in the marketplace.
NRV is an entity-specific value whereas fair value is not.
Net realisable value for inventories may not equal fair value less costs to sell.
4.3 Why is it important?
Every entity wants to sell its inventory above cost i.e. at profit. But sometimes inventories are sold even below cost i.e. at loss for many reasons. Technically speaking loss means that entity was unable to recover all the costs incurred. It might be because goods are damaged or so outdated that no one wants to buy them anymore.
In such situations if entity keeps the carrying value of inventory unchanged i.e. at cost then it is not justifiable as the value of inventory is not the same as its cost now. Therefore, in such situations entity will have to reduce the value of inventory to such value which is expected to be realized on the sale of such inventory. Because if it is not reduced then financial statements may not give true and fair view of the business as far as the inventories are concerned.
4.4 How NRV policy is applied?
Usually the inventories are written down on item by item basis but if there are large amount of inventories then it will be much convenient to have inventories classified in different groups on the basis of their use and nature. In such case each group on whole will be examined for NRV purposes.
Items should be grouped on the basis of their nature and use. For example, entity might be holding three different types of finished goods. It might be inappropriate to write down inventories on the basis of inventory classification i.e. all the finished goods are written down. Entity should examine the three groups under finished goods separately.
4.5 How NRV can be measured?
NRV comprises the best estimates of price and the selling costs. It even includes such fluctuations in price and cost due to subsequent events which are indicative of conditions which were present at the year end.
The estimate of NRV can be derived from the contracts an entity has made with other firms or it can be derived from general market price prevailing at the time estimates are made.
4.6 NRV of Material and Supplies
What is “material” and “supplies”?
Materials are such items which are converted into finished goods and supplies are such items which are consumed in the conversion process. Entity sells finished items and not the materials and supplies. Because of this the written down treatment of these two types of inventories is a bit different.
When material and suppliers are written down?
Materials and Supplies are not written down below the cost if the finished good in which they have been used will be sold at or above cost i.e. the cost incurred on finished goods is expected to be recovered in full. However, if finished items NRV falls below the cost then material and supplies will also be written down to their respective NRV.
How NRV for material and supplies is measured?
As material and supplies are not sold by the entity therefore to estimate NRV, replacement cost is used.
What if NRV increases again after inventory was written down?
If entity still holds such inventory which was written down to NRV in the previous period and later the selling price increased then the amount written down will be reversed. Reversible can be made maximum up to the total amount originally written down previously and not beyond.
How written down value is treated?
Any difference in cost and NRV, where NRV is lower than cost, will be written-down and it will be recognized as an expense in the period it is written down or loss occurred.
How reversals are treated?
In case of reversal of written-down value, such amount will be set-off against the amount of inventory which is treated as expense in the period in which the reversal occurs.
How capitalized inventory is treated?
If inventories have been capitalized in the cost of another asset, for example, self-constructed asset, then in such case amount of inventories will form part of the depreciation expense of the asset.