Inventory is usually the largest current asset of a trading or manufacturing business, so the figure at which it is carried moves both profit and the statement of financial position. If closing inventory is overstated, cost of sales is understated and profit is overstated.
This topic covers the International Accounting Standard (IAS) 2 rule that inventory is measured at the lower of cost and net realisable value, what counts as cost, how to find net realisable value, and how the first in, first out (FIFO) and weighted average formulas give different figures from the same purchases.
It follows inventory year-end adjustments, which showed how closing inventory enters cost of sales. Here we ask how that closing figure is valued. The Institute of Chartered Accountants of Nigeria (ICAN) exam tests this in almost every diet, with Section A items on what is included in cost and on FIFO or average calculations, and written questions on net realisable value and the cost of raw materials. The next topic covers provisions and contingencies.
In 30 seconds
Measure inventory at the Lower of cost and net realisable value (NRV), item by item. Cost is the purchase price after trade discount, plus import duties, non-recoverable taxes and carriage inwards, plus conversion costs for a manufacturer. Leave out selling, administration, storage and abnormal waste. Ignore settlement discounts and recoverable value added tax (VAT). NRV is the expected selling price less costs to complete and costs to sell.
For interchangeable items assign cost by FIFO or Weighted average, never last in, first out (LIFO). When prices rise, FIFO gives a higher closing inventory and a higher profit than weighted average. A write-down is Dr Cost of sales, Cr Inventory.
The IAS 2 rule
The valuation of inventory affects cost of sales, profit and total assets, so it matters a great deal for reporting. IAS 2 requires inventories to be measured at the lower of cost and net realisable value (IAS 2, paragraph 9). Inventories are assets held for sale in the ordinary course of business, assets in the process of production for such sale, and materials or supplies to be consumed in production (paragraph 6).
The reason is prudence, the answer to May Diet 2021, Section A, Question 2. Assets should not be carried at more than the amount expected to be recovered from them (paragraph 28). Net realisable value is usually higher than cost, so inventory is usually valued at cost. It falls below cost when inventory is damaged, becomes obsolete, or its selling price falls, or when the cost of completing or selling it rises.
What goes into cost
Cost comprises all costs of purchase, costs of conversion and other costs of bringing inventory to its present location and condition (paragraph 10).
| Component | Included | Notes |
|---|---|---|
| Purchase cost | Purchase price after trade discount, import duties, non-recoverable taxes, carriage inwards and handling | Recoverable VAT is excluded. Settlement discounts are ignored (paragraph 11). |
| Conversion cost | Direct labour, and variable and fixed production overheads | For a manufacturer. Fixed overheads are absorbed on normal capacity (paragraphs 12 and 13). |
| Other costs | Only costs of bringing the item to its present location and condition | Paragraph 15. |
| Excluded | Abnormal waste, storage costs (unless needed before a further production stage), administrative overheads, selling and distribution costs | Expensed in the period (paragraph 16). |
Purchase cost example. Kumo Consumer Electrics takes delivery of 1,000 units of component X. The quoted price is ₦1,200 per unit with a 5% trade discount, a 2% settlement discount that it intends to take, import duties of ₦60 per unit and a delivery cost of ₦5,000. Cost = 1,000 × 1,200 × 95% = 1,140,000, plus duties 60,000, plus delivery 5,000 = ₦1,205,000. The intention to take the settlement discount is irrelevant.
Conversion cost example. A control unit uses component X at ₦1,205, component Y at ₦800 and sundry materials at ₦150, a total of ₦2,155. It takes two hours of labour at ₦300 an hour, which is ₦600. Factory rent of ₦16,500 and energy of ₦7,500 are production overheads absorbed over a normal 1,000 hours, so (16,500 + 7,500) ÷ 1,000 × 2 hours = ₦48. Cost per unit = 2,155 + 600 + 48 = ₦2,803. Selling and administrative costs of ₦10,000 are not part of inventory.
Net realisable value
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 (paragraph 6). Compare cost and NRV for each item or group of similar items, not for inventory in total (paragraph 29).
| Item | Cost ₦ | Selling price ₦ | Selling costs ₦ | NRV ₦ | Value ₦ |
|---|---|---|---|---|---|
| A1 | 8,000 | 7,800 | 500 | 7,300 | 7,300 |
| A2 | 14,000 | 18,000 | 200 | 17,800 | 14,000 |
| B1 | 16,000 | 17,000 | 200 | 16,800 | 16,000 |
| C1 | 6,000 | 7,500 | 150 | 7,350 | 6,000 |
| Total | 43,300 |
Only A1 is written down. The gain on A2 is not set against the loss on A1. The write-down is Dr Cost of sales, Cr Inventory, and in the exam it is the amount by which cost exceeds NRV (May Diet 2024, Question 5).
Materials held for production. Raw materials are not written down below cost if the finished goods they go into are expected to sell at or above cost (paragraph 32). Frayo Ltd holds materials that cost ₦300,000 and now have a market price of ₦245,000. The finished goods will sell for ₦550,000 after conversion costs of ₦125,000 and selling costs of ₦40,000.
The value recoverable through the finished goods is 550,000 − 125,000 − 40,000 = ₦385,000, which is above ₦300,000, so the materials stay at ₦300,000.
Cost formulas: FIFO and weighted average
Items that are not interchangeable, or that are segregated for a specific project, are costed by specific identification (paragraph 23). For the large numbers of interchangeable items in most businesses, IAS 2 allows two formulas (paragraph 25): first in, first out (FIFO) and weighted average cost. LIFO is not allowed, and an entity must use the same formula for all inventories of a similar nature and use.
Under FIFO the first items bought are assumed to be the first sold, so closing inventory is the most recent purchases. Under weighted average a new average cost is worked out after each purchase and used for issues until the next purchase.
Example. A company has 100 units at ₦50. It buys 300 at ₦60 (5 April), 500 at ₦70 (14 July) and 200 at ₦80 (22 October), and sells 800 units, leaving 300. The goods available cost ₦74,000. FIFO leaves the latest 300 units, which are 200 at ₦80 and 100 at ₦70, so closing inventory is ₦23,000 and cost of sales is ₦51,000. Weighted average, recalculated after each purchase, gives closing inventory of ₦21,090 and cost of sales of ₦52,910.
How the method changes profit
Both methods start from the same ₦74,000 of goods available, so the choice only decides how that cost is split between cost of sales and closing inventory.
| Method | Cost of sales ₦ | Closing inventory ₦ |
|---|---|---|
| FIFO | 51,000 | 23,000 |
| Weighted average | 52,910 | 21,090 |
| Difference | 1,910 | 1,910 |
When prices are rising, FIFO charges the older, cheaper costs to cost of sales and leaves the newer, dearer costs in inventory. It therefore gives the lower cost of sales, the higher closing inventory and the higher profit, here by ₦1,910. When prices fall the effect reverses. Over the whole life of the business the total profit is the same, and only the timing differs.
The ideas in more depth
Background (IAS 2). The weighted average may be calculated on a periodic basis or as each shipment is received (paragraph 27). A periodic average uses one rate for the whole period, which is total cost divided by total units available. Fixed production overheads are absorbed on normal capacity, and low output does not raise the cost per unit (paragraph 13).
Jayek Ltd, for example, absorbs fixed overheads of ₦25,950,000 over a normal 150,000 buckets, which is ₦173 a bucket, although it made only 120,000 (May Diet 2021, Question 6(b)).
Policy and disclosure. A change from FIFO to weighted average is a change in accounting policy, not a change in estimate (May Diet 2021, Section A, Question 15). The financial statements disclose the policy including the cost formula, the carrying amount by classification, the amount recognised as an expense, any write-down and any reversal and why, and inventories pledged as security (paragraph 36).
A physical count is not a required disclosure (Section A, Question 16 of the same diet). If circumstances change and NRV rises, the write-down is reversed, but only up to the original write-down (paragraph 33). Inventory taken by the owner is valued at cost and charged to drawings, as the previous topic showed.
Sources: IAS 2 Inventories, paragraphs 6, 9 to 13, 15, 16, 23, 25, 27 to 29, 32, 33 and 36.
Worked example: Ilorin Paints Ltd
Scenario. Ilorin Paints Ltd began March with 200 drums at ₦1,000. It bought 400 drums at ₦1,200 on 8 March and 300 drums at ₦1,300 on 22 March. It sold 300 drums on 15 March and 400 drums on 28 March, all at ₦2,000 a drum. Required: cost of sales and gross profit under FIFO and under weighted average, and the effect of an NRV test on the 200 drums left if they can be sold for ₦1,250 with selling costs of ₦50 a drum.
- FIFO. The 15 March issue is 200 at 1,000 plus 100 at 1,200, which is 320,000, leaving 300 at 1,200. After the 22 March purchase there are 300 at 1,200 and 300 at 1,300. The 28 March issue is 300 at 1,200 plus 100 at 1,300, which is 490,000.
Cost of sales = 810,000.
Closing inventory = 200 at 1,300 = 260,000.
Sales are 700 × 2,000 = 1,400,000, so gross profit = ₦590,000. - Weighted average. After 8 March there are 600 drums costing 680,000, an average of 1,133.33. The 15 March issue of 300 costs 340,000, leaving 300 drums at 340,000. After 22 March there are 600 drums costing 730,000, an average of 1,216.67. The 28 March issue of 400 costs 486,667.
Cost of sales = 826,667.
Closing inventory = 200 × 1,216.67 = 243,333.
Gross profit = ₦573,333. - Compare. FIFO profit is higher by 16,667, which equals the difference in closing inventory (260,000 − 243,333).
- NRV test (FIFO).
NRV per drum = 1,250 − 50 = 1,200, so 200 drums are worth 240,000.
Cost is 260,000, so write down by ₦20,000: Dr Cost of sales 20,000, Cr Inventory 20,000. - Result. Closing inventory 240,000, cost of sales 830,000 and gross profit 570,000.
- Check.
Goods available cost 200,000 + 480,000 + 390,000 = 1,070,000.
Less closing inventory of 240,000 gives 830,000.
It agrees.
Common mistakes in the exam
- Including selling or administrative costs in the cost of inventory.
- Deducting a settlement discount from cost, or adding recoverable VAT.
- Forgetting to deduct costs to complete as well as selling costs when finding NRV.
- Comparing total cost with total NRV instead of item by item.
- Under FIFO, taking closing inventory from the oldest purchases instead of the latest.
- Not recalculating the weighted average after each purchase in a ledger card.
- Writing raw materials down to market price when the finished goods will sell above cost.
- Absorbing fixed overheads on actual output instead of normal capacity.
Quick revision
- Inventory = lower of cost and NRV, item by item.
- Cost = purchase price after trade discount + duties + carriage inwards + conversion costs. Exclude selling, administration, storage and abnormal waste.
- NRV = selling price − costs to complete − costs to sell.
- Allowed formulas: FIFO and weighted average. LIFO is not allowed.
- Rising prices: FIFO gives higher closing inventory and higher profit.
- Write-down: Dr Cost of sales, Cr Inventory.
Practice questions
These are original questions in the style of the ICAN exam. Try each one first.
Section A style: multiple choice
Question 1. Under IAS 2, inventory is measured at:
- Cost
- Selling price
- The lower of cost and net realisable value
- The higher of cost and net realisable value
Show the answer
C. IAS 2, paragraph 9, requires the lower of cost and net realisable value.
Question 2. Which of these is NOT part of the cost of inventory?
- Non-recoverable import duty
- Carriage inwards
- Selling costs
- Direct labour used in conversion
Show the answer
C. Selling costs are expensed. The others are part of purchase or conversion cost.
Question 3. A company buys 500 units at a list price of ₦2,000 with a 10% trade discount and pays carriage inwards of ₦30,000. The supplier offers a 2% settlement discount, worth ₦18,000, which the company expects to take. The cost of the inventory is:
- ₦882,000
- ₦912,000
- ₦900,000
- ₦930,000
Show the answer
D. 500 × 2,000 × 90% = 900,000, plus 30,000 carriage = 930,000. The settlement discount is ignored.
Question 4. An item cost ₦48,000. It can be sold for ₦52,000 after ₦6,000 of further work and ₦2,000 of selling costs. It should be valued at:
- ₦48,000
- ₦46,000
- ₦44,000
- ₦52,000
Show the answer
C. NRV = 52,000 − 6,000 − 2,000 = 44,000, which is below cost of 48,000.
Question 5. Opening inventory is 100 units at ₦20. Purchases are 200 units at ₦25 and then 100 units at ₦30. 250 units are sold. Closing inventory under FIFO is:
- ₦3,750
- ₦4,250
- ₦3,000
- ₦4,500
Show the answer
B. 150 units remain, 100 at ₦30 and 50 at ₦25, which is 3,000 + 1,250 = 4,250. Option A is the periodic weighted average.
Question 6. When prices are rising, weighted average compared with FIFO gives:
- Higher profit and higher closing inventory
- The same profit
- Lower profit but higher closing inventory
- Lower profit and lower closing inventory
Show the answer
D. Average cost is below the latest cost, so closing inventory is lower and cost of sales higher.
Question 7. Which cost formula is NOT permitted by IAS 2?
- FIFO
- Weighted average
- Specific identification for non-interchangeable items
- LIFO
Show the answer
D. Paragraph 25 allows only FIFO or weighted average for interchangeable items.
Question 8. Raw materials cost ₦300,000 and their market price has fallen to ₦250,000. The finished goods they go into will sell above cost. They should be valued at:
- ₦300,000
- ₦250,000
- ₦275,000
- ₦550,000
Show the answer
A. Materials are not written down below cost when the finished goods will sell at or above cost (paragraph 32).
Question 9. The weighted average method is used. Opening inventory is 200 units at ₦80, then 300 units are bought at ₦100, and 250 units are issued. The cost of the issue is:
- ₦21,000
- ₦23,000
- ₦25,000
- ₦20,000
Show the answer
B. Average = (16,000 + 30,000) ÷ 500 = 92. Issue = 250 × 92 = 23,000. Option A is the FIFO cost.
Question 10. A change from FIFO to weighted average is:
- A change in accounting policy
- A change in accounting estimate
- The correction of an error
- Not allowed under IAS 2
Show the answer
A. It changes the basis of measurement, so it is a change in accounting policy. Both formulas are allowed.
Section B style: written questions
Question 11 (10 marks). (a) State the costs included in, and the costs excluded from, the cost of inventories under IAS 2. (6 marks) (b) Explain the FIFO and weighted average cost formulas. (4 marks)
Question 12 (20 marks). Ekiti Plastics Ltd has four items of inventory at 31 December. Figures are in naira.
| Item | Cost | Expected selling price | Costs to complete | Selling costs |
|---|---|---|---|---|
| A | 600,000 | 800,000 | 50,000 | 40,000 |
| B | 900,000 | 950,000 | 120,000 | 60,000 |
| C | 450,000 | 480,000 | 0 | 30,000 |
| D | 1,200,000 | 1,100,000 | 150,000 | 50,000 |
(a) Calculate the net realisable value of each item. (6 marks) (b) State the value of inventory for the statement of financial position and the write-down required. (6 marks) (c) Give the journal for the write-down. (3 marks) (d) Explain why the comparison is made item by item and how a later recovery in price is treated. (5 marks)
A further written question
Question 13 (10 marks). A store has 100 units at ₦40. On day 10 it buys 200 units at ₦46. On day 15 it issues 150 units. On day 20 it buys 100 units at ₦52. On day 25 it issues 120 units. Prepare the inventory ledger under (a) FIFO and (b) the weighted average method, and state the cost of the issues and the closing inventory under each. (10 marks)
Model answers
Show the model answer to Question 11
(a) Included: the purchase price after trade discounts, import duties and non-recoverable taxes, carriage inwards and handling, and for manufactured goods the conversion costs of direct labour and production overheads, with fixed overheads absorbed on normal capacity. Excluded: abnormal waste, storage costs (unless needed before a further production stage), administrative overheads, selling and distribution costs, settlement discounts and recoverable VAT.
(b) FIFO assumes the first items bought are the first sold, so closing inventory is valued at the most recent costs. Weighted average works out a new average cost after each purchase, from the cost of items on hand and the cost of the new purchase, and uses it to cost issues until the next purchase.
Show the model answer to Question 12
(a)
- A: 800,000 − 50,000 − 40,000 = 710,000.
- B: 950,000 − 120,000 − 60,000 = 770,000.
- C: 480,000 − 0 − 30,000 = 450,000.
- D: 1,100,000 − 150,000 − 50,000 = 900,000.
(b) Lower of cost and NRV: A 600,000, B 770,000, C 450,000, D 900,000, a total of ₦2,720,000. Cost is 3,150,000, so the write-down is ₦430,000 (B 130,000 and D 300,000).
(c) Dr Cost of sales 430,000, Cr Inventory 430,000.
(d) IAS 2 usually requires item-by-item comparison (paragraph 29), so a surplus on one item cannot hide a loss on another. Comparing totals would show a write-down of only 320,000.
If the circumstances that caused the write-down no longer exist, the write-down is reversed up to the original amount (paragraph 33). The reversal reduces the cost of sales in that period.
Show the model answer to Question 13
(a) FIFO.
- Day 10: 100 at 40 and 200 at 46, a total of 13,200.
- Day 15: issue 100 at 40 plus 50 at 46 = 6,300, leaving 150 at 46 = 6,900.
- Day 20: add 100 at 52 = 5,200, so 150 at 46 and 100 at 52 = 12,100.
- Day 25: issue 120 at 46 = 5,520, leaving 30 at 46 and 100 at 52 = 6,580.
- Cost of issues.
6,300 + 5,520 = 11,820. - Closing inventory = 130 units, ₦6,580.
(b) Weighted average.
- Day 10: 300 units cost 13,200, average 44.
- Day 15: issue 150 at 44 = 6,600, leaving 150 at 6,600.
- Day 20: 250 units cost 11,800, average 47.20.
- Day 25: issue 120 at 47.20 = 5,664, leaving 130 units at ₦6,136.
- Cost of issues.
6,600 + 5,664 = 12,264.
Check: 18,400 of goods available less closing inventory equals the cost of issues in each case.
Pathfinder on Inventory valuation (IAS 2): FIFO, weighted average and NRV
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Asks which costs are included in or excluded from the cost of inventories under IAS 2, such as selling costs, conversion costs and carriage inwards.
Revise first: What goes into cost
From the previous syllabus. Asks which measure of inventory is acceptable, what IAS 2 deals with, why inventory is written down to net realisable value, whether a change from FIFO to weighted average is a change in estimate, and what IAS 2 does not require to be disclosed.
Revise first: The IAS 2 rule
Asks for the closing inventory under FIFO and the cost per unit under weighted average from opening inventory of 250 units, purchases of 750 units and an issue of 500 units.
Revise first: Cost formulas: FIFO and weighted average
From the previous syllabus. Asks you to explain cost and net realisable value (4 marks) and to describe two methods of arriving at cost under IAS 2 (4 marks).
Revise first: Cost formulas: FIFO and weighted average
From the previous syllabus. Asks you to explain inventory (3 marks), then to find the cost and net realisable value of four used cars with reconditioning costs, further costs and selling expenses of 5% of price, and the value of each (17 marks).
Revise first: Net realisable value
From the previous syllabus. Asks for the cost of plastic buckets sold under FIFO, from opening inventory, production costs and fixed overheads absorbed on normal capacity.
Revise first: Cost formulas: FIFO and weighted average
From the previous syllabus. Asks you to explain inventories (3 marks), the costs included (8 marks) and excluded (4 marks), then to calculate the cost of imported and local raw materials and the cost per unit of finished product (5 marks).
Revise first: What goes into cost
From the previous syllabus. Question 1(b) includes inventory costing ₦4,500,000 that can be sold for only ₦1,688,000. Question 6(a) asks for an inventory ledger under weighted average cost for a year and the closing inventory.
Revise first: Cost formulas: FIFO and weighted average
Asks for the components of measuring inventory under IAS 2 (6 marks), the net realisable value of three items (6 marks), the lower of cost and NRV (3 marks), the total adjustment (2 marks) and the journal (3 marks).
Revise first: Net realisable value
Most diets ask which costs belong in inventory, or a FIFO or weighted average calculation, or the lower of cost and net realisable value. Check Section A of every diet you practise.
Revise first: What goes into cost
Source: ICAN Pathfinder, Financial Accounting. Diets covered: May Diet, 2016, November Diet, 2016, May Diet, 2017, November Diet, 2017, May Diet, 2018, May Diet, 2019, November Diet, 2020, May Diet, 2021, November Diet, 2021, May Diet, 2022, November Diet, 2022, November Diet, 2023 and May Diet, 2024 (the later ones are not all on the previous syllabus). Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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