IAS 2 Inventories: Measurement, Cost Formulas and Common Issues

IAS 2 Inventories is the accounting standard that governs how businesses value and account for their inventory — the goods they hold for sale, are producing, or will use in production. Since inventory is a major asset for many businesses, getting its valuation right is important. This practical guide explains what IAS 2 covers, the key valuation rule, how cost is determined, the permitted cost formulas, and net realisable value — in plain language. It's a core financial-reporting topic, relevant to ACCA and AAT study.

The key rule: lower of cost and NRV

The central principle of IAS 2 is that inventories must be measured at the lower of cost and net realisable value (NRV). This reflects the prudent idea that an asset should not be carried at more than the amount expected to be recovered from selling it. In most cases cost is lower, so inventory is held at cost — but where inventory is damaged, obsolete, or its selling price has fallen, NRV may be lower, and the inventory must be written down. Understanding both "cost" and "NRV" is therefore the heart of applying the standard.

What is included in cost?

Under IAS 2, the cost of inventories comprises all costs of bringing them to their present location and condition. This includes:

• Costs of purchase — the purchase price, plus import duties and other non-recoverable taxes, and transport and handling costs, less trade discounts and rebates.
• Costs of conversion — for manufactured goods, the direct costs (such as direct labour) plus a systematic allocation of fixed and variable production overheads.
• Other costs incurred in bringing inventories to their present location and condition.

Equally important is what is excluded from cost and instead expensed: abnormal amounts of wasted materials, labour or overheads; storage costs (unless necessary in the production process); administrative overheads not related to production; and selling costs. Excluding these prevents inventory being overstated.

The permitted cost formulas

When individual units of inventory are interchangeable, it's impractical to track the cost of each one, so IAS 2 permits cost formulas to assign costs:

• First-In, First-Out (FIFO) — assumes the items purchased first are sold first, so closing inventory is valued at the most recent costs.
• Weighted average cost — values items at the average cost of all similar items, recalculated as new purchases are made.

A crucial point is that LIFO (Last-In, First-Out) is not permitted under IAS 2. The same cost formula must be used consistently for all inventories of a similar nature and use.

Net realisable value (NRV)

Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the costs necessary to make the sale. It is an entity-specific value, distinct from fair value. Inventory is written down to NRV when its cost may not be recoverable — for example, because it is damaged or obsolete, selling prices have fallen, or the costs to complete or sell have risen. The write-down is recognised as an expense in the period. If the circumstances reverse and NRV recovers, a previous write-down can be reversed (up to the original cost).

Why IAS 2 matters

IAS 2 matters because inventory valuation directly affects both the balance sheet (the value of a major current asset) and the income statement (through cost of sales, and therefore profit). Inconsistent or overstated inventory valuation can materially distort reported results. By prescribing the lower-of-cost-and-NRV rule, defining what costs are included, and limiting the cost formulas, IAS 2 brings consistency and prudence to a significant area of the accounts. For accountants, it's a fundamental and frequently-examined standard.

Frequently asked questions

How is inventory valued under IAS 2?

At the lower of cost and net realisable value (NRV). Cost is used unless NRV is lower — for example, when inventory is damaged, obsolete or its selling price has fallen.

What is included in the cost of inventory?

Costs of purchase (price, duties, transport, less discounts), costs of conversion (direct costs plus a share of production overheads), and other costs of bringing inventory to its present location and condition.

What cost formulas does IAS 2 allow?

FIFO (first-in, first-out) and weighted average cost. LIFO is not permitted. The same formula must be used consistently for similar inventories.

What is net realisable value?

The estimated selling price in the ordinary course of business, less the estimated costs to complete and to make the sale. Inventory is written down to NRV when its cost may not be recoverable.

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