IAS 2 permits the use of approximations when determining the cost of inventories. Widely-used approximations include the standard cost method and the retail method (IAS 2.21-22). The standard cost method takes into consideration typical levels of materials, labour, efficiency, and capacity utilisation. On the other hand, the retail method bases the cost of inventory on selling prices, adjusted downwards by a profit margin. Typically, an average percentage is employed, as it’s unrealistic to consider all elements influencing the selling price of specific merchandise. Such averaging is expressly permitted by IAS 2.22.
For many businesses, tracking the cost of identical inventory items on a unit-by-unit basis is infeasible. As a result, IAS 2 permits the use of either the first-in, first-out (FIFO) method or a weighted average cost formula to represent inventory movements.
Let’s explore this further.
Interchangeable inventories
Cost of interchangeable inventories, which aren’t allocated for a specific project, should be determined using either the FIFO or weighted average cost formula. The chosen formula should be consistently applied to all inventories of similar nature and use to the entity (IAS 2.25-26).
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FIFO method
FIFO method presumes the earliest purchased or produced inventories are sold first. Thus, items still in inventory are the most recently acquired or made (IAS 2.27).
Example: FIFO method
On 1 January 20X1, Entity A has 1,000 units of product X, each costing $10. January 20X1 sees the following purchases:
| Date | Volume | Cost per item |
|---|---|---|
| Opening balance | 1,000 | $10 |
| 5 January | 300 | $9.5 |
| 11 January | 200 | $9.7 |
| 20 January | 400 | $9.6 |
By the end of January 20X1, Entity A has sold 1,400 units of product X, leaving 500 units. Using the FIFO method, the 500 units left comprise 400 items bought on 20 January at $9.6 each and 100 items from 11 January at $9.7 each. The closing inventory value is $4,810. The cost of goods sold is $13,820, calculated as:
| Date of purchase | Volume | Cost per item | Total cost in P/L |
|---|---|---|---|
| Opening balance | 1,000 | $10 | $10,000 |
| 5 January | 300 | $9.5 | $2,850 |
| 11 January | 100 | $9.7 | $970 |
| Total | 1,400 | $13,820 |
Weighted average cost
This method calculates the cost of each inventory item from the weighted average cost of similar items at the start and throughout a period. It can be determined periodically or upon each delivery (IAS 2.27).
On 1 January 20X1, Entity A holds 1,000 units of product X, each costing an average of $10. January sees the following purchases:
| Date | Volume | Cost per item |
|---|---|---|
| Opening balance | 1,000 | $10 |
| 5 January | 300 | $9.5 |
| 11 January | 200 | $9.7 |
| 20 January | 400 | $9.6 |
| Opening balance + purchases | 1,900 | $9.81* |
* Refer to the downloadable Excel file.
By January’s end, 1,500 units of product X are sold, leaving 400. These 400 are valued at $3,924 (400 x $9.81). The cost of the 1,500 sold units is $14,715 (1,500 x $9.81).
LIFO method
The LIFO method (last-in, first-out) is not permitted as explained in IAS 2.BC9-BC21. However, businesses can adopt specific costing formulas that align actual physical inventory flows with direct costs, potentially yielding LIFO-like results.
Inventories that are not interchangeable
Inventories that aren’t typically interchangeable should have their costs specifically identified. This approach also applies to items designated for a particular project (IAS 2.23-24).
Consignment arrangements
Inventories delivered to another party (like a dealer or distributor) under a consignment arrangement remain on the delivering party’s statement of financial position until the criteria for revenue recognition are satisfied. Such consignment arrangements are outlined in IFRS 15.B77-B78.
Recognition in P/L
Upon sale of inventories, their carrying amount becomes an expense in the same period as the corresponding revenue is recognised. If inventories are used in creating other assets, they form part of that asset’s cost. Any reductions to the net realisable value (and their reversals) are immediately recognised in P/L (IAS 2.34-35).
More about IAS 2
See other pages relating to IAS 2:
IAS 2: Scope, Definitions and Disclosure
IAS 2: Cost of Inventories
IAS 2: Cost Formulas (FIFO, LIFO and Weighted Average Cost)
IAS 2: Net Realisable Value (NRV)