IAS 2 Inventories: Cost, Net Realisable Value, FIFO and Weighted Average

For a trader or manufacturer, inventory is often the largest current asset, and the amount at which it is carried feeds straight into cost of sales and profit. Overstate closing inventory by ₦100 and profit is overstated by ₦100.

International Accounting Standard (IAS) 2 Inventories decides what inventory is, what goes into its cost, when it must be written down, and which methods may be used to work out cost when items are bought at different prices. This topic covers those rules, the periodic and perpetual recording systems, inventory counts and the disclosures. The next topic starts revenue from contracts with customers.

The topic is examined every sitting, often inside the main accounts question. In May Diet, 2022, the compulsory question included damaged inventory whose cost was compared with its selling price less the cost of repair. The write-down was charged to cost of sales. Read cash-generating units and the impairment of goodwill first.

Definition and recording

Inventories are assets that are:

• held for sale in the ordinary course of business (a retailer’s stock; a manufacturer’s finished goods);
• in the process of production for sale (work in progress); or
• in the form of materials or supplies to be used in the production process (raw materials).

Two ways of recording

• Periodic system. Opening inventory and purchases are transferred to cost of sales at the year end, and closing inventory, found by a count and valued, is credited to cost of sales and shown as an asset. Cost of sales is therefore opening inventory plus purchases less closing inventory. A lost item is not in the closing count, so it is automatically charged to cost of sales.
• Perpetual system. One inventory account records every receipt and issue, so the balance is always the inventory held. Issues go to cost of sales. Returns to suppliers and returns from customers are recorded in the inventory account, and normal and abnormal losses are written out of it.

Inventory counts

A physical count is vital for the periodic system and a check on the perpetual one. Differences between the account and the count may come from theft, unrecorded damage, items posted to the wrong code, or a receipt or issue that was not recorded. They are investigated and the account adjusted.

If the count is made on a date other than the reporting date, the figure is adjusted: add back the cost of inventory sold since the reporting date and deduct the cost of purchases received since then.

Measurement: lower of cost and net realisable value

Cost

IAS 2 says the cost of inventories comprises all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

• Purchase cost: the purchase price after trade discounts (not settlement discounts), plus import duties and other non-recoverable taxes, plus carriage inwards and handling costs directly attributable to the purchase. Recoverable sales tax is excluded. Intending to take a settlement discount does not change cost.
• Conversion costs: costs directly related to units of production, such as direct labour, and fixed and variable production overheads. Fixed overheads, such as factory rent, depreciation of factory equipment and factory management pay, are allocated on the basis of normal production capacity, even if output was lower. The unabsorbed amount is an expense of the period.
• Other costs: only those needed to bring the item to its present location and condition.

Excluded from cost, and expensed as incurred:

• abnormal amounts of wasted materials, labour or other production costs
• storage costs, unless needed in the production process before a further stage
• administrative overheads that do not contribute to bringing the inventory to its present location and condition
• selling and distribution costs

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. It is usually higher than cost, so inventory is usually valued at cost. It is lower when items are damaged, wholly or partly obsolete, or when selling prices have fallen.

Cost and net realisable value are compared for each item or for groups of similar items, not for inventory as a whole.

If net realisable value is below cost, the inventory is written down. In a periodic system with no special accounting during the year, the closing inventory is simply measured at the lower amount. If the need is found after the draft accounts were prepared, closing inventory is reduced and cost of sales increased. In a perpetual system the inventory account is credited and cost of sales debited.

If circumstances later change so that net realisable value rises, the write-down is reversed, but only up to the amount of the original write-down.

Cost formulas

Where the actual cost of each item can be identified, as with large, expensive or non-interchangeable items, that cost is used (specific identification). For interchangeable items, one of two formulas is used, and the same formula must be used for all inventories with a similar nature and use.

• First in, first out (FIFO): items are assumed to be used in the order they were bought, so closing inventory is made up of the most recent purchases. It is used with both periodic and perpetual systems.
• Weighted average cost (AVCO): issues are costed at the weighted average cost per unit, which is the cost of inventory in store plus the cost of new items, divided by the units in store plus the units received. It is easier to apply in a perpetual system, where a new average is calculated after each purchase. In a periodic system a single average for the year may be used.

Last in, first out (LIFO) is not permitted. The choice of formula changes profit, because closing inventory changes cost of sales. In a period of rising prices FIFO gives a higher closing inventory and a higher profit than average cost.

Disclosure

The notes disclose the accounting policy including the cost formula; the total carrying amount classified appropriately (for a manufacturer, raw materials, work in progress and finished goods); the amount carried at net realisable value; the amount written down and recognised as an expense; the circumstances that led to a write-down; and the amount and circumstances of any reversal.

The ideas in more depth

Why normal capacity

If fixed overheads were spread over actual output, a quiet year would load each unit with more cost. Inventory would be carried at an inflated amount that the market would not pay. Using normal capacity means idle capacity is expensed in the year it occurs.

Why item by item

Comparing in total would let a gain on one item hide a loss on another. A loss in value is recognised at once, but an expected gain is not, which is a prudent approach.

Sources and references

• IAS 2 Inventories: definition, measurement, cost formulas, net realisable value, recognition as an expense and disclosure.

These points are stated as at 5 November 2026.

Worked examples

1. Price after trade discount.
   2,000 × ₦900 × 90% = ₦1,620,000.
2. Import duty.
   2,000 × ₦45 = ₦90,000.
3. Delivery. ₦8,000.
4. Cost.
   ₦1,620,000 + ₦90,000 + ₦8,000 = ₦1,718,000.
   The settlement discount is ignored.

1. Fixed overhead rate.
   ₦1,600,000 ÷ 80,000 = ₦20 a unit.
2. Unit cost.
   ₦120 + ₦45 + ₦15 + ₦20 = ₦200.
3. Absorbed.
   60,000 × ₦20 = ₦1,200,000 goes into inventory and cost of sales.
4. Expensed.
   ₦1,600,000 − ₦1,200,000 = ₦400,000 is an expense of the period for idle capacity.

1. A.
   Net realisable value ₦11,000 − ₦600 = ₦10,400, below cost: ₦10,400.
2. B.
   ₦26,000 − ₦300 = ₦25,700, above cost: ₦20,000.
3. C.
   ₦9,500 − ₦250 = ₦9,250, above cost: ₦9,000.
4. D.
   ₦14,000 − ₦1,500 − ₦500 = ₦12,000, below cost: ₦12,000.
5. Total.
   ₦10,400 + ₦20,000 + ₦9,000 + ₦12,000 = ₦51,400.
   The write-down (₦1,600 on A and ₦3,000 on D) goes to cost of sales.

1. Total cost available.
   ₦8,000 + ₦18,000 + ₦30,000 + ₦16,500 = ₦72,500 for 1,500 units.
   Closing units: 300.
2. FIFO.
   Closing inventory is the latest 300 units at ₦55 = ₦16,500.
   Cost of sales ₦72,500 − ₦16,500 = ₦56,000.
3. Weighted average.
   ₦72,500 ÷ 1,500 = ₦48.33 a unit.
   Closing inventory 300 × ₦48.33 = ₦14,500.
   Cost of sales ₦72,500 − ₦14,500 = ₦58,000.
4. Profit effect. FIFO cost of sales is ₦2,000 lower, so gross profit is ₦2,000 higher.

1. Add back sales at cost.
   ₦4,200,000 + ₦350,000 = ₦4,550,000.
2. Deduct purchases received.
   ₦4,550,000 − ₦520,000 = ₦4,030,000.

How to answer in the exam

• Define and state the rule. List the three kinds of inventory, then the lower of cost and net realisable value.
• Calculate cost. Show each component. Deduct only trade discounts, and leave out selling, storage and administration costs.
• Calculate net realisable value. Selling price less costs to complete less costs to sell, item by item.
• Cost formulas. Show the units and prices in a table, then the closing inventory, then cost of sales as a check.
• Show the entry. For a write-down, Dr Cost of sales and Cr Inventory.

Common mistakes in the exam

• Using replacement cost as net realisable value.
• Comparing total cost with total net realisable value instead of item by item.
• Forgetting to deduct the cost to complete or repair when finding net realisable value.
• Including selling or administration costs in cost.
• Absorbing fixed overheads on actual output when it is below normal capacity.
• Deducting a settlement discount from cost.
• Using LIFO.

Quick revision

• Measure at the lower of cost and net realisable value, item by item.
• Cost: purchase + conversion + other costs to present condition and location. Exclude selling, administration, abnormal waste, storage.
• Fixed overheads on normal capacity.
• Net realisable value: selling price less costs to complete and sell.
• FIFO or weighted average; no LIFO. Write-down to cost of sales; reversal capped.
• Count after the year end: add back sales at cost, deduct purchases.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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