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(this technical article will be useful to the students of AAT Level 4, Financial Statements unit and the students of ACCA paper F7, Financial Reporting).

IAS-2 is one of the oldest standards and is entirely based on the accounting concept of prudence. It stipulates that the closing inventory should be valued at the lower of the following:
a - cost
b - Net Realisable Value

The cost will include the following:
Cost of purchase, any input tax (if not claimable), transportation charges and any other charge which is necessary to bring to product to your premises
Cost of conversion/manufacturing including all the manufacturing overheads

While calculating the costs, you should not include the following:

abnormal wastage
storage costs
selling costs
admin overheads (unless they can be linked to production)
interest and finance costs on borrowing

Two methods of costing are allowed: FIFO and Average Cost. LIFO is not allowed under the revised standard.

Net Realisable Value:
Estimated selling price minus any extra costs required (for examples, transport outward and selling commission).

The big question here is what is the logic behind this standards. As mentioned above, the logic is based on the accounting concept of prudence. Applying it to the context, you can not book the profit (hidden within the selling price) until you have actually sold the product.

Let us take some practical examples:

1 - You have 100 items of a product in stock as at 31st December (your accounting year end). They cost you £75 each and you normally sell them for £110.
Question: what would be the valuation of your closing inventory of this product as of 31st December?
Ans: Lower of £7500 (£75x100) and £11000 (£110*100) = £7500

The question here is why can't you value the inventory at the market value especially you normally sell it at £110/piece? The answer is that you have not sold it as on 31st December. Anything can happen between the year end and the day you sell it actually. Moreover, even if you manage to sell it at your normal selling price (£110) after 31st December but before the actual date you signed your accounts, you still can not value it at your selling price. This is because, under Revenue Recognition, you can recognise the revenue only when you sell. And further, until you recognise revenue, you can not recognise your profit in the books.

2 - You have 100 items of a product in stock as at 31st December (your accounting year end). They cost you £75 each and you normally sell them for £110. However, you know that you had to sell these products at the price of £95 each in February. This information was known to you when you signed your accounts.
Question: what would be the valuation of your closing inventory of this product as of 31st December?
Ans: The answer would still be the same as to Question 1 above: Lower of £7500 (£75x100) and £9500 (£95*100) = £7500.
This is because even though the actual selling price (£95) was lower than your normal selling price, your cost (£75) was still lower than that.

3 - You have 100 items of a product in stock as at 31st December (your accounting year end). They cost you £75 each and you normally sell them for £110. However, you had to sell these items for £62 each due to change in customer preferences. This information was known to you when you signed your accounts.
Question: what would be the valuation of your closing inventory of this product as of 31st December?
Ans: Lower of £7500 (£75x100) and £6200 (£62x100) = £6200.

Therefore, applying prudence principle, you recognised your losses (in the third example) but did not recognise profits (in the first two examples).

Moreover, the standards requires that you carry out your valuations for each class of inventory and not for the overall total figures.

For example, you have three types of products in stock:

Product  Quantity  Total Cost  Total Expected Sales Value 
A 100  £5500  £8500 
10  £780  £680 
70  £5600  £7000 
Total 180 £11880 £16180

Here, you can not take £11880 as the value of your closing inventory, you have to consider valuation of each product separately. 

Therefore, the answer would be: £5500 (for product A) + £680 (product B) and £5600 for (product C) = £11780

This standard does not apply to work-in-progress for construction contracts; financial instruments and products and agricultural and biological products. 

Please note that the standard applied to valuation for the purpose of formal financial reporting and you are free to apply any suitable method for your internal management accounts. However, for the sake of convenience and conformity, it would be good to apply the same for internal reporting and monthly or periodical management accounts. 

Bharat Shah (B.Com; A.C.A.; M.B.A.) has over 15 years of industrial experience at senior level and teaches at Learning Academy. He has taught ACCA / AAT subjects at FE and private colleges. The views expressed herein are the personal views of the author and not necessarily of the organisation. 

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