Acca f3 Financial Accounting (int) Study Text

142

8: Inventory   Part D  Recording transactions and events 

FIFO

$

$

Year 2 

 

 

Sales 

 

 12,000

Opening inventory

1,700

Purchases

3,800

5,500

Closing inventory

       0

Cost of sales

5,500

Gross profit

6,500

5 IAS 2 Inventories 

Inventory should be valued at the lower of cost and net realisable value. 

IAS 2 lays out the required accounting treatment for inventories (sometimes called stocks) under the 

historical cost system. The major area of contention is the cost 

value of inventory to be recorded. This is 

recognised as an asset of the enterprise until the related revenues are recognised (ie the item is sold) at 

which point the inventory is recognised as an expense (ie cost of sales). Part or all of the cost of 

inventories may also be expensed if a write-down to 

net realisable value is necessary. 

In other words, the fundamental accounting assumption of 

accrual requires costs to be matched with 

associated revenues. In order to achieve this, costs incurred for goods which remain unsold at the year 

end must be carried forward in the statement of financial position and matched against future revenues.

5.1 Scope 

The following items are 

excluded from the scope of the standard. 

 

Work in progress under 

construction contracts (covered by IAS 11 Construction contracts, which

you will study in later financial accounting papers). 

Financial instruments (ie shares, bonds) 

Livestock, agricultural and forest products, and mineral ores 

5.2 Definitions 

The standard gives the following important definitions. 

Inventories are assets: 

 

– 

held for sale in the ordinary course of business; 

 

– 

in the process of production for such sale; or 

 

– 

in the form of materials or supplies to be consumed in the production process or in the 

rendering of services. 

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. 

(IAS 2)

Inventories can 

include any of the following. 

Goods purchased and held for resale, eg goods held for sale by a retailer, or land and buildings 

held for resale 

Finished goods produced

Work in progress being produced 

 

Materials and supplies awaiting use in the production process (

raw materials)

Key terms 

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Part D  Recording transactions and events

  8:  Inventory

143

5.3 Measurement of inventories 

The standard states that 

'Inventories should be measured at the lower of cost and net realisable value.'

This is a very important rule and you will be expected to apply it in the exam. 

5.4 Cost of inventories 

The cost of inventories will consist of all the following costs. 

(a)

Purchase

(b)

Costs of conversion

(c) 

Other costs incurred in bringing the inventories to their 

present location and condition 

5.4.1 Costs of purchase

The standard lists the following as comprising the costs of purchase of inventories. 

(a)

Purchase price; plus

(b)

Import duties and other taxes; plus

(c) 

Transport, handling and any other cost 

directly attributable to the acquisition of finished goods, 

services and materials; less

(d)

Trade discounts, rebates and other similar amounts. 

5.4.2 Costs of conversion 

Costs of conversion of inventories consist of two main parts. 

(a) Costs 

directly related to the units of production, eg direct materials, direct labour 

(b) Fixed 

and 

variable 

production overheads that are incurred in converting materials into finished 

goods, allocated on a systematic basis. 

You may have come across the terms 'fixed production overheads' or 'variable production overheads' 

elsewhere in your studies. The standard defines them as follows. 

Fixed production overheads are those indirect costs of production that remain relatively constant 

regardless of the volume of production, eg the cost of factory management and administration. 

Variable production overheads are those indirect costs of production that vary directly, or nearly 

directly, with the volume of production, eg indirect materials and labour. 

(IAS 2)

The standard emphasises that fixed production overheads must be allocated to items of inventory on the 

basis of the 

normal capacity of the production facilities. This is an important point. 

(a)

Normal capacity is the expected achievable production based on the average over several 

periods/seasons, under normal circumstances. 

(b) 

The above figure should take account of the capacity lost through 

planned maintenance.

(c) 

If it approximates to the normal level of activity then the 

actual level of production can be used. 

(d)

Low production or idle plant will not result in a higher fixed overhead allocation to each unit. 

(e)

Unallocated overheads must be recognised as an expense in the period in which they

were incurred. 

(f) 

When production is 

abnormally high, the fixed production overhead allocated to each unit will be 

reduced, so avoiding inventories being stated at more than cost. 

(g) 

The allocation of variable production overheads to each unit is based on the 

actual use of

production facilities. 

Exam focus 

point

Key terms 

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