International Accounting Standards 2 – Inventories

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Introduction

International Accounting Standards (IASs) were established to govern and control the accounting practice. The guidelines were nevertheless used between 1973 and 2000. The rules were then controlled and regulated by a commission which was later replaced by a board, the International Accounting Standards Board (IASB) in the year 2001. Since 2001, IASB has continuously amended some IAS and to some greater extent, they have incorporated some International Financial Reporting Standards (IFRS). The board and the commission have therefore fully defined some specific rules on how inventories are to be handled. This paper seeks to analyze how the IAS or IFRS handles inventories in the accounting practice.

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The objectives of IAS 2

The clause provides some guidelines on how inventories should be handled. The rule also establishes when and to what extent the inventory cost should be determined. In order to follow the double-entry rule, it also determines how and when to recognize an expense (Summaries of international financial reporting standards, 2010). The clause also acknowledges the written-down costs of inventories which are usually recorded at their net realizable values. It, therefore, contains the costing formulas which should be used when assigning costs to the inventories. The core objective of IAS 2 is thus to prescribe the inventory measurement parameters which should be used to recognize assets to be recorded in the balance sheet and also the number of expenses to be recorded in the income statement (IAS 2 Inventories, 2008). The rule also provides that the inventory cost be written down at their net realizable value.

The scope

Inventories are goods held for resale purposes. They can however be held in three major stages (finished goods, work in progress, and raw materials) different accounting procedures are followed for each of them. To ensure clarity, the IAS 2 clause excludes inventories from the construction contracts, financial instruments, and biological assets since they are provided by IAS 11, IAS 39 and IAS 41 respectively (International Accounting Standards Board, 2008, p.964).

Comparison with the US GAAP

The GAAP principles usually account for the inventories when placed, but the IAS uses the order upon which inventories are sold. They can therefore use either first-in-first-out (FIFO) or last-in-first-out (LIFO) method (Key differences between IFRS and the US GAAP, 2004). All they require the firm to ensure is consistency on the method selected. However the two principles require that inventories be stated at the lower cost. For the inventories that constantly decline their value they are required to be written down. The IAS allows the reversal of the written down inventories if their value happens to rise, but the US GAAP doesn’t (Inventory Accounting: Differences between US GAAP and International Standards, 2007).

Inventories measurements

According to IAS 2.10, inventories should be valued at their purchase price. This cost should be inclusive of the transportation cost that the firm incurs in delivering the goods to their location. The value-added tax and handling cost should equally be added to the purchase cost in order to ensure that the firm does not incur any loss in its operations (Kolitz, Quinn & McAllister, 2009, p.331). However, the firm should ensure that it excludes any trade discount that it may have been given due to the quantity or volume of sale or even due to the mode of payment used by the firm. If the goods were to be further processed by the firm, the conversion cost and all other extra costs that may be essential in transforming the product to its final state will be included before coming up with the overall inventory measurement (Wittsiepe, 2008, p.88). Firms can also opt to use the standard or retail valuation method provided the cost approximates the actual cost. These methods are mainly allowed when firms decide to skip the many stages involved in determining the inventory costs.

The rule however does not allow firms to use the inventory cost interchangeably. This limitation ensures that no double counting is experienced when recording inventories in the books of account. The rule therefore provides that same formula should be used in valuing similar in nature and use inventories. However, for the different inventory characteristics, different formulas may be used, but further justification must be provided to support the valuation process. In addition the rule limits the firms to use the abnormal waste or loss that are incurred during the production process (Epstein & Jermakowicz, 2008, p.52). This is because including such amounts will not only overstate the inventory figures but will also mislead the financial statement users. Although the rule allows firms to include the tax, transport and handling costs, they are not allowed to include the warehousing costs. The main reason why the clause excludes the storage costs when valuing their inventories is that this is fixed cost which the firm should continuously incur regardless of whether they have inventories or not.

The administration overhead should also be excluded if not related to the actual production of goods in the firm. This is because only the costs that are directly related to the production of goods should increase the inventory value. By including the unrelated costs will amount to overstatement of the inventory cost which consequently leads to misrepresentation in the accounting records. The selling costs are also excluded when determining the inventory costs (Greuning & World Bank, 2006, p.97). This is because selling does not add any value to the goods, but instead it seeks to ensure that firms earn revenue by selling their existing stocks. The foreign exchange difference that may arise due to the currency value fluctuation should also not be included when determining the inventory cost. Such cost mainly influences the currently acquired inventories.

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The reduction or increase of currencies compared to others in the international markets does not affect the cost of the inventories as they occur afterward (Devine, 1980, p.25). Including such fluctuations will either overstate or understate the real value and cost of inventories. In case the inventories are purchased on hire purchase of through differed payments; the interest incurred on the prices are not included in the inventory valuations. The net realizable value of inventories is obtained by deducting both the estimated cost of completion and other necessary costs which improves the status of the product to the estimated ordinary selling price of a commodity.

Disclosures

According to IAS 2 the firm should ensure that it follows the required accounting policies for inventories. This rule enables consistency in the accounting practice which consequently improves the reliability of the statements. All the firms are also required to account for inventories at the lower value or market value. The rule ensures that firms do not overstate the inventories figure which can give some misleading information. The written-down amount is considered to be an expense to the firm. The amount should therefore be used to lower the overall profit in the firm (International Accounting Standards Committee Foundation & International Accounting Standards Board. 2007, p.839). All the costs that are directly involved in the production process i.e. labor costs, packaging and operational costs. This is because the cost significantly contributes to the improvement of the overall status of the products. All these costs should be added up to the cost of purchases in order to assist the firm to arrive at a viable price that will maximize profits.

A financial statement extract

Below is an income statement extract for a small manufacturing firm (Tracy, 2008, p.78).

$ $
Sales (300 x 160,000) 48,000
Less: Cost of sales
Opening Stock (200 x 20,000) 4,000
Production (180,000 x 200) 36,000
40,000
Less: Closing Stock (40,000 x 200) (8,000) (32,000)
Gross profit 16,000
Less: Selling & Administration Expenses: Variable 4,000
Fixed 2,000 (6,000)
Net profit 10,000

Discussion

Inventory cost is very important when computing net profit for a firm. This is because the firm deducts the cost of inventories from sales to arrive at the gross profit (Pinson, 2007, p.66). The expenses are then further deducted from the gross profit in order to arrive at the net profit. It is important to understand that the cost of sales is calculated by summing up opening stock (inventories) with the production costs (Tracy, 2009, p.14). In this case the production cost is the cost directly involved in the production process. They therefore add value to the final products. The closing inventories value is then deducted to arrive at the specific cost of sales. An overstatement or understatement may lead to misrepresentation in the financial statements (Wessels, 2000, p.574).

Conclusion

Accounting standards regulate the accounting practice and also ensure consistency in the way firms account for their assets and liabilities. The main objective of IAS 2 is thus to prescribe the inventory measurement parameters which should be used to recognize assets to be recorded in the balance sheet and also the number of expenses to be recorded in the income statement. Inventories are goods held for resale purposes. They can however be held in three main stages (finished goods, work in progress and raw materials) different accounting procedures are followed for each of them. IAS 2 is a clause that stipulates the treatments that should be accorded to inventories. This rule enables consistency in the accounting practice which consequently improves the reliability of the statements.

Reference List

Devine, C.T., 1980. Inventory valuation and periodic income. New York, Ayer Publishing. (Online). Web.

Epstein, B.J., & Jermakowicz, E.K., 2008. IFRS Policies and Procedures. New Jersey, John Wiley and Sons. (Online). Web.

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Greuning, H.V., & World Bank. 2006. International financial reporting standards: a practical guide. Washington, World Bank Publications. (Online). Web.

IAS 2 Inventories. 2008. International Financial Reporting Standards. (Online). Web.

Inventory Accounting: Differences between US GAAP and International Standards. 2007. Financial-education. (Online). Web.

International Accounting Standards Board. 2008. International Financial Reporting Standards IFRS 2008. London, Kluwer. (Online). Web.

International Accounting Standards Committee Foundation & International Accounting Standards Board. 2007. A guide through International Financial Reporting Standards (IFRSs) 2007: including the full text of the Standards and Interpretations and accompanying documents issued by the International Accounting Standards Board as at 1 January 2007; with extensive cross-references and other annotations. London, Kluwer. (Online). Web.

Key differences between IFRS and the US GAAP. 2004. IAS Plus. (Online). Web.

Kolitz, D.L., Quinn, A.B. & McAllister, G.A., 2009. A Concepts-Based Introduction to Financial Accounting. Lansdowne, Juta and Company Ltd. (Online). Web.

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Pinson, L., 2007. Keeping the Books: Basic Recordkeeping and Accounting for the Successful Small Business. Chicago, Kaplan Publishing. (Online). Web.

Summaries of international financial reporting standards.2010. IAS Plus. (0nline). Web.

Tracy, J., 2008. Accounting For Dummies. Indiana, For Dummies. (Online). Web.

Tracy, J. A., 2009. How to Read a Financial Report: Wringing Vital Signs Out of the Numbers. New Jersey, John Wiley and Sons. (Online). Web.

Wessels, W.J., 2000. Economics. New York, Barron’s Educational Series. (Online). Web.

Wittsiepe, R., 2008. IFRS for Small and Medium-Sized Enterprises: Structuring the Transition Process. London, Gabler Verlag. Web.

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